Owning dividend-yielding stocks is a great way to generate income. But many investors don't fully understand the ins and outs of dividends and how to identify the risks and rewards. Here are six simple points to consider if you're ready to buy some stocks that pay you to own them.
1. How much can a company pay?
When a company pays a dividend, it pays out a percentage of its profits to its shareholders. That percentage its called the payout ratio. If the payout ratio stays below 100%, the dividend is considered safe, though there are varying levels of safety. If it exceeds 100%, the dividend could be cut.
For example, PepsiCo (NYSE:PEP) currently has a payout ratio of 64%, which is calculated by dividing its dividend payments per share by its earnings per share over the past 12 months. Rival Coca-Cola (NYSE: KO) has a higher payout ratio of 111%, which makes it a less attractive income investment as it seems more likely Coca-Cola will have to cut its dividend based on how much money it is making.
2. Why chasing a high yield can be dangerous
Companies usually pay out dividends on a quarterly, semi-annual, or annual basis. When we divide the annual dividend by the current stock price, we get the stock's yield. PepsiCo currently pays out a quarterly dividend of $0.81, which equals an annual dividend of $3.24 per share.
Dividing $3.24 by its stock price as of this writing ($115.84) equals 2.8%, which is PepsiCo's current yield. That's notably lower than Coca-Cola's 3.3% yield, but investors should recall that PepsiCo has a lower payout ratio, which gives it more room for future dividend increases.
The key lesson for income investors is that a high yield doesn't always indicate that a stock is a good income investment. That yield must be supported by a reasonable payout ratio and stable earnings growth, or it could be a high-yield trap.
3. Consistent, growing dividends are good
If a company grows its earnings and keeps its payout ratios below 100%, it should be able to regularly raise its dividends. Companies that consistently raise their dividends are often considered great long-term investments.
If an S&P 500 company raises its dividend annually for over 25 years and meets some other criteria, it becomes a elite Dividend Aristocrat. Both PepsiCo and Coca-Cola, which have respectively raised their dividends annually for 44 and 54 years, belong to that group.
4. Reinvest your dividends
If you plan to hold an income stock over several years or decades, it's wise to reinvest the dividends through a Drip, or dividend reinvestment plan. These plans allow you to automatically use dividend payments to purchase additional shares of the stock -- usually at a discount to the market price and without an additional commission.
Over time, automatic additional purchases of stock help you even out your cost basis via dollar-cost averaging. More importantly, the more shares you accumulate, the more your annual dividend payments grow -- which grows your investment through the "magic" of compounding.
For example, if you had invested $10,000 in PepsiCo on Aug. 30, 1997, but didn't reinvest your dividends, your investment would be worth about $32,000 today. But if you had enrolled in a Drip, that investment would be worth nearly $55,000.
5. Understand the trade-off between income and growth
Companies usually only start paying dividends if they run out of room to grow. That's because a younger, higher-growth company has a need to reinvest all of its profits and cash into expanding its business.
Once a company runs out of meaningful ways to expand, paying dividends gives investors a reason to keep holding the stock. However, investors should realize that trade-off means the stock's price probably won't rise as much as it did in the past.
6. Track valuations and interest rates
Lastly, income investors should track a stock's price-to-earnings ratio and its correlation to interest rates. Low interest rates over the past few years caused many income investors to shift from bonds to higher-yielding dividend stocks.
This caused the P/E of many dividend stocks to hit historic highs as their price rose. Coca-Cola, for example, currently trades at 48 times earnings, which is much higher than the industry average of 32 for soft-drink makers. As interest rates climb and make bonds more attractive again, income investors could rotate out of dividend stocks -- which could quickly deflate the ones with premium valuations.
The key takeaways
I'm a huge fan of income investing, since it's a great way to stay focused on long-term growth. However, investors should always see if a dividend stock has solid earnings growth, a sustainable payout ratio, a record of dividend increases, and a reasonable valuation before they buy shares.