If you're in the market for dividend-paying stocks for your portfolio, you're making a smart move. The power of dividends is often underappreciated, and that can be a costly mistake. Consider this: "From 1930 to 2019, dividend income's contribution to the total return of the S&P 500 index averaged 42%," according to the folks at Hartford Funds.
Imagine that you have a portfolio valued at $300,000, with an overall average dividend yield of 4%. That will kick out $12,000 to you annually, offering an average $1,000 of monthly income that will be very welcome in retirement -- or can be reinvested in additional shares of stock to keep your portfolio growing.
Don't just jump into dividends without learning a little about them first, though. Here are five useful tips to know.
No. 1: Bigger isn't better
Beginner investors may want to grab the fattest dividend yield they can find, and there are often at least a few companies with yields topping 10%. It may seem hard to pass up such a hefty payout, but frequently it will be the right thing to do -- because very big yields can be a sign of companies in trouble.
Remember the math: A dividend yield is simply a company's annual dividend payment divided by its current stock price. So a $40 stock paying a $2 annual dividend (typically $0.50 per quarter) has a yield of 5% -- $2 divided by $40. But if the company falls on hard times and its stock price falls to $20, the yield will shoot up to 10% -- $2 divided by $20. If the hard times persist, the company may well reduce, suspend, or eliminate its payout, as many companies have done. That said, there are occasional terrific opportunities, when yields are high. You just need to do your due diligence.
No. 2: Favor fast-growing dividends
Next, don't make the mistake of assuming that a 4% dividend yield is better than a 3% one. A dividend's growth rate is very important. Some companies increase their payouts only a little every year or two, while others are in the midst of robust annual increases. Over several years, a 3% yield can become an effective yield of 5% or 6% or more. If you're invested for a long time in healthy and growing dividend payers that are increasing their payouts at a good clip, you can expect to collect more and more from them each year.
No. 3: Check the payout ratio
It's also useful to examine the payout ratio of any dividend payer you're considering. The payout ratio is calculated by dividing the annual dividend amount by the annual earnings per share (EPS). Imagine, for example, Buzzy's Broccoli Beer (ticker: BRRRP), which pays quarterly dividends of $1 and sports EPS of $8. To get the payout ratio, you'd divide total dividends of $4 by the EPS of $8, and you'd get 0.50, or 50%. That reveals Buzzy's is paying 50% of its earnings in dividends, and a 50% ratio is pretty good -- because it suggests that the company shouldn't have too much trouble maintaining its dividend, and better still, that the dividend has room to grow.
Payout ratios that approach or exceed 100% are not ideal. Still, every company and its situation are different. Dig into any company you're considering to get more details. Perhaps its EPS was simply low this year because of some special circumstances, or maybe it's growing its earnings so briskly that it should be able to cover its payouts.
No. 4: Seek high-quality dividend payers and buy them at a good price
Next, be sure that any dividend-paying company you invest in is a high-quality one, ideally with little to no debt and plenty of cash, with growing revenue and earnings and profit margins, and sustainable competitive advantages. You also want to buy into any company at a good price. Buying into a terrific company when it's grossly overvalued can result in your shares losing value as they fall closer to their intrinsic value.
No. 5: Reinvest those dividends
Finally, once you're happily invested in some solid companies, collecting meaningful payouts every quarter, reinvest those dividends if you can. Doing so can really turbocharge your portfolio's performance, because that dividend money can add many more shares to your collection, whether you're adding shares of companies you already own or shares of companies new to your portfolio.
Let's revisit the earlier hypothetical $300,000 portfolio with the overall 4% yield. It will deposit about $12,000 in cash dividends into your account, and it's up to you what to do with that money. If you reinvest it and it grows at an annual average of 8%, it will be worth about $56,000 in 20 years. Remember that in the following year, you'll likely collect another $12,000 -- or, very possibly, more -- perhaps $13,000. You can see how this is an effective way to build wealth.
So go ahead and seek some great dividend stocks for your portfolio. Just keep the guidelines above in mind.