Dividends can play an important role in any investor's portfolio. They shouldn't represent all your investments, but investing in dividend-paying stocks can create a great source of income down the road. For older companies whose stock price might not have room for hypergrowth, dividends provide a way to incentivize and reward investors. And when you look at many investors' total returns, a large portion of that comes from dividends.
As you're investing in dividend-paying stocks, be sure to dig a little deeper into the companies to make sure you're making the right choice and not being fooled by what's on the surface. When it comes to dividends, all that glitters ain't gold.
Image source: Getty Images
Look beyond the dividend yield
Often, the most advertised metric of dividend stocks is the dividend yield. A company's dividend yield is its annual dividend payout relative to its stock price. If a company pays out $2 in dividends yearly and its stock price is $100, its dividend yield is 2%.
But that's exactly why dividend yield by itself can be misleading. If that same company's stock price dropped to $50, its new yield would be 4%. Without digging deeper, that increase in the yield may seem lucrative, but it doesn't give a backstory into why the yield doubled -- namely, that the stock price declined by half.
In this case, the stock's price might have dropped significantly because of factors that don't have anything to do with its underlying business, or it could've dropped because something substantial changed with the business and its operations. Whatever the case, you always want to be aware of it, so you're not blindly investing.
Don't overlook the payout ratio
It's one thing to have a solid dividend-paying stock, but you want to make sure the yield is sustainable over the long run. That's where a company's payout ratio can come in handy. The payout ratio tells you how much of its earnings a company is paying out in dividends. You can calculate the dividend payout ratio by dividing a company's yearly dividend by its earnings per share (EPS), both of which can be found on your broker's platform or the company's financial statements.
A payout ratio above 100% means the company is paying out more in dividends than it's bringing in. Spoiler alert: That isn't a good thing. If a company keeps paying out more than it's bringing in, that's unsustainable in the long term. At some point, the dividend will either need to be cut, or the company will run out of money. Neither is good for investors focusing on dividends.
There's no established number that you should be looking for when examining a company's payout ratio because some industries are more dividend-favorable than others. But in general, you want to look for ratios between 30% and 50%, give or take.
Dividends can be a supplement in retirement
One great thing about dividends is they can provide supplemental income in retirement. If you're intentional with your dividend investing and taking advantage of your broker's dividend reinvestment program (DRIP) -- which automatically reinvests dividends to buy more shares of the company or fund that paid them -- you can easily find yourself in a situation where you receive thousands in monthly retirement income. All it takes is time and consistency.
Along the way, though, remember not to be fooled by misleading dividend yields; look deeper into the why. You'll likely find (and hopefully avoid) red flags along the way.
