Dividend stocks can be a great addition to your portfolio. On top of the cash they provide, dividends offer other benefits to long-term shareholders. Chief among them are the discipline that dividends enforce on companies' managements and the signaling power they provide regarding what those management teams really think about their companies' prospects.
Still, there's more to successful dividend investing than simply looking for the biggest dividends you can find. Keep reading to learn about some key things to look for in determining whether a dividend-paying company might deserve a place in your portfolio or whether it's one you might want to avoid.
Looks too good to be true? It's probably a trap!
Dividend-paying companies within a given industry tend to have similar dividend yields, and a company with a very high yield compared with its peers may very well be what's known as a dividend trap. That's a company that the market believes won't be able to maintain its dividend because of underlying financial troubles.
Take cemetery operator and funeral-services provider StoneMor Partners (STON), for instance. It currently sports a $0.33-per-share dividend per quarter and a whopping 16.4% dividend yield. Yet it's losing money, and Moody's recently put a negative outlook on its debt rating, which already sits well in the "junk bond" range. Companies must prioritize their debt service ahead of their dividend payments, or else the bondholders can force a default and change of control.
StoneMor Partners has already slashed its dividend to this level, and by pricing its shares with a 16% yield even after that cut, the market is indicating that another reduction is likely. Contrast StoneMor Partners' yield with funeral services industry leader Service Corporation International (SCI 2.67%), which is both profitable and trades with a mere 1.7% dividend yield, reflecting the market's far higher confidence in its ability to continue paying that dividend.
Know how well the dividend is covered
Dividends are typically cash payments, and to make those payments, companies have to have the cash available. The only way that's even close to sustainable is for the companies to earn that money from their operations and then pay a portion of those earnings over to their shareholders. A company's "payout ratio" measures how much of a company's earnings get paid to shareholders from its dividend.
Take fast-food titan McDonald's (MCD -1.29%). It currently pays $3.76 per share per year in dividends and has earned $5.44 per share over the past year. That puts its payout ratio at about 69% of earnings, and that means McDonald's pays its owners a little over two-thirds of what it earns and holds on to the other third to have money to cover future growth and expansion opportunities.
A payout ratio that's much higher than McDonald's -- say above 75% or so -- could be considered a sign of a dividend at risk. After all, companies need some flexibility to make sure they can cover unexpected expenses as well as their growth plans. That said, there are some companies in specialized industries that frequently pay out above that level, but they are the exception, rather than the general rule.
Get a feel for its growth prospects
Dividend-paying companies frequently attempt to increase their dividends over time as the profitability of their businesses allows. Canadian pipeline giant Enbridge (ENB 1.09%) has announced that it expects to be able to increase its dividend by 10% to 12% per year between now and 2024, which is a pretty lofty goal to announce publicly.
What gives Enbridge the confidence to announce that goal is that its primary business is moving energy around through pipelines, making it essentially an energy toll road. As the political flak over things like the Keystone XL pipeline expansion shows, it's hard to get approval to build pipelines. Once that approval is granted, it still takes a lot of capital to actually build. That combination gives existing pipeline operators such as Enbridge a fairly high level of confidence in its future earnings growth potential.
In addition, Enbridge recently completed the purchase of U.S.-based Spectra Energy. Linking the two businesses together gives Enbridge the opportunity to find cost savings throughout the combined company, which would generate additional profits.
Solid dividend stocks can play a great role in your portfolio
Dividend stocks whose payouts are well covered by their earnings and that have the opportunity to increase their dividends over time can play an excellent role in your portfolio. Just make sure you're not overly tempted by high-yielding dividend traps. It's the total package that matters, not just the current yield.
Instead, focus on fundamentally strong businesses with the operating strength to maintain their dividends and enough buffer to handle the unexpected twists the economy throws their way. That way, you'll be more likely to own the strong companies that can make dividend stock ownership an ultimately profitable endeavor.