Investing in dividend stocks can be a great way to generate income and even beat the market over the long term. But not all dividends or dividend stocks are the same, so investors need to look beyond the yield at the company in which they're investing and consider how a dividend will perform long term.
Here are a few tips when looking at dividend stocks.
Not all dividend yields are created equal
When looking for dividend stocks, investors shouldn't focus too much on a stock's dividend yield, which is the dividend per share paid in a year divided by the current stock price. A high yield can be attractive on the surface, but it can also be a warning that the market sees rough days ahead if it's driven by a dropping stock price.
Two great examples of what can go wrong with high-yield stocks are Seadrill and Kinder Morgan, two stocks that were once investor favorites because of their yields. Seadrill was a popular offshore-drilling play with a yield in the high single digits until oil prices crashed in 2014 and the business took a nosedive. Customers canceled existing long-term drilling contracts, new contracts for deepwater drilling became scarce, and Seadrill's debt became a burden too heavy to carry. Eventually, the company filed for bankruptcy protection, showing how quickly a high dividend yield can go wrong.
Kinder Morgan's story is similar, but without the disastrous ending. The company had to slash its dividend in 2015 when earnings from exploring for fossil fuels and transporting them across the country fell. It continues to pay that annual dividend of $0.50, but has announced its intention to increase the 2018 dividend to $0.80 per share, a 60% increase.
This isn't to say that a high yield is always bad. But investors should remember that they're buying part of a business when purchasing a stock, not just a dividend. Analyze the underlying strength of the business and don't get lost in the yield a stock pays, because sometimes, high yields don't last.
Dividend growth can pay off long term
Low dividend yields might look less tempting than large ones, but growth over time is key. You may buy a stock that yields 2% from a dividend today, but if the dividend payout grows 15% for the next 10 years, your implied dividend in year 10 will be 8.1% of your purchase price.
Two great examples of this are 3M and Procter & Gamble. Both companies have been paying dividends for over a century and have increased dividends every year for decades.
If you had bought a share of 3M and a share of P&G on the first day of trading in 1990, they would have cost $19.40 and $8.75, respectively. Today, 3M's dividend is $5.44 annually and P&G's is $2.76 per share. Neither stock yields over 4% at the current stock price, but that doesn't mean they haven't been great dividend payers over time. Even with small increases each year, a growing dividend can yield great returns for investors long term.
Look for the hidden low-tax dividends
Did you know there are high-yield dividend stocks that pay dividends to reduce, or even avoid taxes altogether? One great example is renewable energy yieldcos, who pay dividends as a "return of capital" to shareholders, and real estate investment trusts (REITs), who have to pay out most of their cash flow to avoid corporate taxes.
On the yieldco side, NextEra Energy Partners is a great example of how an energy company can be low-tax for investors. Not only does the company itself expect to pay little in U.S. federal taxes over the next 15 years, it expects the next eight years or more in dividend payments to investors to be treated as a return of capital. In other words, investors won't owe taxes on the current 4.2% dividend yield, effectively increasing the amount of money investors can put in their pockets.
Another great option is municipal bond ETFs. The interest earned on municipal bonds typically aren't subject to federal taxes and aren't taxed by most states, so funds that own municipal bonds and distribute payments to shareholders avoid taxes in the same way. An example is the Pimco Municipal Income Fund, which "seeks to provide current income exempt from federal income tax", and has a yield of 5.7% today. There are even state-specific options, like the Eaton Vance California Municipal Income Trust, which currently has a yield of 4.1%, and whose "objective is to provide current income exempt from regular federal income tax and California state personal income taxes".
Investors can boost their after-tax yield by looking for low-tax dividends like yieldcos and municipal bond fund ETFs.
Don't forget, you're still investing in a company
At the end of the day, whether you're looking at a high-yield stock, a growth dividend, or a dividend as a way to avoid taxes, investors should remember that they're investing in a company (or assets in the case of a bond fund). If the underlying fundamentals of the company itself aren't strong, then the dividend won't be built to last, either.
Dividend investors should look for companies with low payout ratios (dividends paid divided by net income) of 5% or less because that indicates a company has room to pay the dividend even if earnings fall for a short period of time. It also gives a company excess cash flow to grow long-term.
Another strong indicator of a healthy dividend is a company growing free cash flow long-term. After all, a dividend comes from the cash flow a business generates, and if there's no cash flow, eventually there's no dividend.