If you're in or approaching retirement, you're likely looking to purchase dividend stocks that not only have the capacity to grow, but also throw off cash on a regular basis. Even if you're a young person, while the conventional wisdom is to invest in high-growth stocks that may not pay a dividend, investing in dividend stocks is a great way to diversify. With a constant and (hopefully) growing stream of cash, dividend stocks afford investors the option of using the cash in their daily lives or reinvesting in order to compound their returns.
Investing in dividend stocks, like most investing principles, is simple, but it's not necessarily easy. Here are a few rules to live by that can help make you wealthier and save you from costly mistakes.
These four dividend rules could make you rich. Image source: Getty Images.
1. Know the rules
Not all stocks play by the same rules when it comes to dividend payouts. For instance, beyond regular common stocks, you can also invest in special classes of dividend-producing equities such as master limited partnerships (MLPs), real estate investment trusts (REITs), and business development corporations (BDCs). Each of these high-yield classes of investments has different rules regarding how much they must pay out as dividends, as well as how they're taxed.
MLPs are usually found in the oil and gas, real estate, and other natural-resource sectors, especially pipelines and storage entities that throw off predictable cash flow. REITs are found in the real estate sector and can be either equity REITs or debt (mortgage) REITs. In addition to residential and commercial REITs, many REITs offer exposure to real estate within specific sectors, such as hospitals. BDCs mainly invest in a portfolio of debt securities but also some equity securities of small- and medium-sized businesses.
All three are considered pass-through entities, which means that they must pay out 90% of their income as dividends. By doing that, they're exempt from corporate taxes. For MLPs, which are considered a partnership, distributions are often classified as a return of capital and aren't taxed as dividends. Rather, the return of capital lowers your tax basis, so investors often only pay taxes when they sell.
Meanwhile, distributions from REITs and BDCs, which are corporations, are often taxed as ordinary income, which can be taxed at a higher rate -- up to 39.6% -- than the qualified dividends of traditional equities, which are taxed only up to 20%.
Here are some words of caution regarding REITs, MLPs, and BDCs. Because they're required to pay out most of their net income as distributions, MLPs, REITs, and BDCs usually have higher dividends than typical stocks. However, in order to grow, they often need to issue more equity or debt to fuel such growth projects. That means organic growth may be hard to come by.
In addition, MLPs tend to be in commodity-related businesses, which can be cyclical and somewhat risky. Finally, all three asset classes are usually highly leveraged, which allows for high dividend yields for equity holders but carries risk.
2. Know the coverage ratio
Once you've located a potential dividend stock you'd like to buy, assess the safety of that dividend. For that, investors should look to the payout ratio, or better yet, the cash dividend payout ratio.
The traditional payout ratio tells you what percentage of a company's net income is paid out as dividends. For instance, a 25% payout ratio means that a company is paying out 25% of its net income as a dividend, with the remaining 75% available for reinvestment in growth, stock buybacks, or paying down debt. Obviously, the lower the payout ratio, the safer the dividend -- at least in theory.
However, an even better measurement to analyze dividend safety is the payout ratio in relation to a company's free cash flow -- called the cash dividend payout ratio. That's because net income may be misleading in certain circumstances. For instance, if a company has very high reinvestment needs, its capital expenditures may be much higher than its non-cash depreciation expenses. As such, the cash flow available for dividends may be lower than the company's headline net income figure.
Net income can also be misleading for the MLP, REIT, and BDC structures mentioned above, because real estate often gets preferred tax treatment with large or accelerated depreciation expenses -- even though real estate tends to appreciate, not depreciate, over time.
Fortunately, these dividend-paying entities often disclose metrics that reflect the true cash flow of the business. For instance, MLPs typically disclose a metric called distributable cash flow in their filings, which is a proxy for maintenance-free cash flow excluding capital expenditures spent on growth projects.
Meanwhile, REITs often give a metric called funds from operations, which adds back the large depreciation expenses that shield REITs from taxes but are a non-cash expense. Both metrics are good measurements of the cash available for distribution to unitholders (for MLPs) or shareholders (for REITs).
3. Assess growth potential
Once you're comfortable with the safety of the dividend and assuming you're a long-term shareholder, investors should assess the potential for their dividends to grow. To analyze the growth potential for the dividend, you not only have to analyze the company's payout ratios but also how much a company's free cash flow per share can grow over time.
This comes down to an analysis of the growth prospects of the underlying business, which will require you to analyze a company's competitive advantages, total addressable market, potential for margin expansion, and management's capital allocation policies -- basically, everything you would normally assess when looking at any stock, dividend payer or not.
Sometimes, the underlying business doesn't even have to grow that much in order for cash flow per share to grow a lot. For instance, in recent years, large U.S. banks have been excellent dividend growth companies, even though these banks have had modest revenue growth. That's because many banks have used a lot of their retained earnings to buy back stock.
Banks have also generally traded at low valuation multiples, allowing management teams to retire anywhere between 5% and 10% of their companies' shares per year, in addition to a small amount of growth. Combined, many banks have been able to grow their earnings per share (EPS) and dividends by double digits, as buybacks have contributed a lot to this per-share growth.
How important is dividend growth? For the long-term investor, a lot. As an example, take Warren Buffett's purchase of American Express stock, which he purchased for the Berkshire Hathaway portfolio between 1993 and 1995. Over these three years, American Express' dividend yield ranged from 2.5% to 5%.
Twenty-five years later, thanks to AmEx's growth, buybacks, and dividend increases, Buffett is now earning roughly an 18.4% dividend yield on the amount he initially paid for American Express stock. Needless to say, for patient long-term dividend growth investors, you don't need to invest in high-yield stocks today in order to achieve high yields many years into the future.
4. Safety first
All of these measures -- knowing the rules, knowing the payout ratio, and assessing growth prospects -- can be assessed to not only judge the health and growth of a company's dividend, but also its risks. For instance, though a company may sport a high yield, it may be forced to cut the dividend in order to pay down debt or to invest in growth if it has a high payout ratio and a stalling or shrinking business. Many investors have been burned by chasing a large dividend yield, only to lose much of their principal when the company decides to cut the payout.
Though it's listed last, this rule should really be first on investors' minds -- thou shalt not lose one's principal when investing in dividend stocks. Violating this rule can negate the entire reason to invest in dividend stocks in the first place, which is to grow, not lose, one's money.
In general, great dividends come from great underlying companies bought at reasonable prices. As such, dividend investing isn't that much different from regular investing. If you learn the above metrics cold and stick to some basic rules, you'll be able to weed out the good from the bad dividend investments in no time.
