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About to Buy Dividend Stocks? Read This First

By Jason Hall – Updated Apr 26, 2017 at 2:46PM

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Dividend stocks can make for great investments, whether it's income, growth, or both you're after. But just like any investing strategy, you can get burned if you're not aware of a few important things.

Dividend stocks have a long history of making for successful investments. After all, a company that gives money back to its shareholders after paying the bills and investing in the business is often a company that's built for long-term success. 

But before you just start investing in stocks that pay a dividend, there are some really important things to consider, depending on what you're looking to accomplish. After all, one dividend stock could be ideal for one person but be completely wrong for you. Keep reading to learn some of the most important things you need to know before buying dividend stocks. 

A "money tree" -- a tree with currency for leaves.

Image source: Getty Images.

The most important number you must understand

Surprise! It's not yield. It's payout ratio. 

The payout ratio is an excellent metric that helps measure the percentage of a company's profits it pays out in dividends. This is important, as it helps you identify if a company's current dividend is sustainable or at risk of getting cut. So how do you determine the payout ratio? Its simply the annual dividends per share divided by earnings per share. 

Two hands; one holding a percent sign, the other holding a dollar sign.

Knowing the yield is important, but understanding how sustainable the dividend is matters even more. Image source: Getty Images.

In general terms, the company's with the most sustainable dividend will have a payout ratio of 70% or less. The idea here is that the company retains 30% or more of earnings for a variety of reasons. First is reinvesting in the business, such as funding capital growth or maintenance of assets, acquiring new businesses, or strengthening the balance sheet by paying off debt or simply building a cash cushion. 

This is especially true for companies in heavily cyclical industries, such as oil and gas or other commodities like mining or steelmaking where demand and prices can swing quickly and wildly. So a company should retain not only enough cash to reinvest in the business, but also enough to sustain itself during downturns. 

It's worth noting that REITs -- real estate investment trusts -- are a category of stocks with different rules, since they are required to pay out 90% of profits to investors.  

Make sure you know what you're buying 

Investors should also make sure to know the difference between a few different kinds of stocks that often pay dividends, including REITs and mREITs, LLCs and MLPs, and how these are different from most common stocks. 

MLPs (master limited partnerships) and often LLCs (limited-liability companies) are a unique kind of investment in that they are more partnership than corporation. Hence, they don't generate corporate profits and therefore pay no corporate taxes. There are a lot of limitations on what kind of business can be structured in this fashion, but it can make them very efficient cash-flow generators. The catch? Since they aren't taxed at the corporate income level, you the unitholder (MLP-speak for shareholder) can be subject to different and often higher taxes than they are with traditional stocks. Uncle Sam will get his pound of flesh one way or another.  

A 401(k) statement and a pen.

Image source: Getty Images.

There's more potential bad news here. Because of something called unrelated business taxable income, or UBTI, you may end up paying taxes on your MLP or LLC dividends in an IRA or 401(k). In general terms, investors should avoid MLPs or LLCs in a retirement account. 

REITs are unique, since they, like every business, must depreciate assets, even though real estate nearly always goes up in value over time. This, when combined with the 90% net income payout rule, means that these stocks are measured a bit differently. Instead of an EPS-based payout ratio, they use FFO per share -- that's funds from operations, which adds depreciation and amortization back into net income -- for a more accurate measure of dividend sustainability. 

mREITs, or mortgage REITs, in general terms, specialize in managing portfolios of commercial real estate debt and mortgages, making money on the "spread" between what they receive in interest and what they must pay for capital to invest in this debt. This adds an additional layer of financial complexity that investors should understand before putting a dime in this class of stocks. 

The biggest mistake to avoid

One of the most common mistakes dividend investors make is looking for high yield, which means they could be investing in a company headed toward a dividend cut. A recent example is offshore-drilling giant Seadrill LTD (SDRL).

A hand reaching for cash in a giant rat trap.

Image source: Getty Images.

For years, Seadrill was a high-yield dynamo, paying investors gobs of cash. At the time, oil was trading for well over $100 per barrel, and the company was investing big-time in growing its fleet of high-spec offshore drilling vessels, almost entirely funded by new debt. 

Fast-forward a few years, and Seadrill is on the brink of declaring bankruptcy, having taken on loads of debt while returning -- in hindsight -- far more cash to shareholders than was prudent. If instead of paying out all its cash in dividends, the company had retained some to fund growth, the company would probably be in a completely different position. 

Before buying a big yielder that could end up like Seadrill, make doubly sure you understand why the yield's so big, and what the likelihood is that the dividend will be cut. Your long-term returns could work out much better in a safer, smaller-yield investment. 

Don't skip these dividend stocks 

Not only can chasing high yield leave you burned, but it can cause you to skip right past some of the very best dividend investments: dividend growth stocks. 

Take American Express Company (AXP 0.20%), for instance. At recent prices, shares of the venerated charge-card and business lending company yield only around 1.6% -- a paltry level that many dividend investors might skip right past. But over the past 20 years, the company has increased its per-share dividend almost 327%, paying investors who bought shares in 1997 and continue to hold them a whopping 6.4% yield on their original investment. Better yet, if they continue to hold, they'll be rewarded even more with future dividend growth. 

The takeaway here is not to make the mistake of skipping small yields, particularly if a company has a strong track record of dividend growth, and a state goal of continuing to increase payouts in the future.

Jason Hall owns shares of American Express and Seadrill. Jason Hall has the following options: long July 2017 $3 calls on Seadrill. The Motley Fool recommends American Express. The Motley Fool has a disclosure policy.

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