The market sell-off has pushed the dividend yield of the S&P 500 from 1.2% at the start of the year to 1.7%. What's more, many individual stocks now yield their highest levels in several years. Investing in stocks that pay consistent and growing dividends is an excellent way to supplement income in retirement or boost your passive income stream. As stock prices fall and dividends stay constant, the yield goes up.

Making passive income without the need to sell stock is alluring. And it could be the right strategy for you. However, there are drawbacks to dividend stocks as well. Let's go through the pros and cons to help you align your investment planning with your risk tolerance and financial goals.

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Why do companies pay dividends in the first place?

The simplest reason why companies pay dividends is to return value to shareholders -- which encourages folks to hold the stock over time. To pay a stable and growing dividend, a company needs its free cash flow (FCF) and earnings to regularly exceed the dividend payout by a wide margin so that even if the performance declines, the company doesn't have to borrow money to support the dividend.

As an example, Procter & Gamble (PG -0.50%) and Coca-Cola (KO -0.80%) not only regularly generate FCF and earnings in excess of the dividend. But they also lack investment options.

In order to grow revenue, these more mature companies can complete mergers and acquisitions, raise prices, or look to sell more products. Selling more products means increasing production, building out the supply chain, and hiring more workers, which may be impractical if the demand isn't there. A company with low growth tends to buy back its stock and pay dividends because it has limited ways to deploy capital effectively. It's not an inherently bad approach; it's just the nature of how mature the company is, its market position, and its industry. 

PG Free Cash Flow Per Share (Annual) Chart

PG Free Cash Flow Per Share (Annual) data by YCharts.

The above chart shows P&G and Coke's FCF, diluted earnings per share, dividends per share, and outstanding shares over the last 20 years. You can see that earnings and FCF growth have coincided with dividend raises and a decrease in outstanding shares due to stock buybacks.

By comparison, a company like Apple pays a more modest dividend as measured by yield. But it uses the bulk of its capital to reinvest in its business and buy back its own stock. So, despite being a mature company, Apple's organic growth prospects give it better ways to boost shareholder value than growing the dividend. Buying back its own stock has also been an effective move because it has boosted earnings per share while also being an excellent investment for Apple and its market-outperforming stock.

Smaller companies that are inconsistently profitable or are in rapid growth mode tend not to pay dividends or buy back their own stock because capital is better allocated toward organic growth.

In sum, an investor can categorize a company into three basic buckets. The first is a mature company that lacks investment opportunities but generates plenty of excess FCF and earnings to support the dividend. The second is a company that has some growth opportunities but is better off blending growth with dividends or buybacks. And the third is a company that has more growth opportunities than capital, so it can't afford to allocate capital outside of its operations.

Pitfalls of some high-yield dividend stocks

In the last section, we assumed that growing FCF and earnings could support dividend raises. After all, Procter & Gamble and Coca-Cola are both Dividend Kings, which are S&P 500 components that have paid and raised their dividends for at least 50 consecutive years.

However, plenty of companies have dividend yields that are "artificially" high because their stock price, earnings, and market share are falling but they haven't yet decreased their dividend payout. But that past passive income stream does little good if the company plans on cutting its dividend soon anyway. And if capital losses exceed the dividend income, you'll still lose money overall.

Investing made simple

The beauty of today is that fractional shares, zero-cost trading, and information access make it easy to customize a portfolio that is right for you. Risk-averse investors who are more concerned with capital preservation than growth may prefer to own a Dividend King like Procter & Gamble or Coca-Cola because a growing payout makes up for their low-growth companies. By comparison, some investors may prefer to own a high-growth company with an exciting product or service suite even though earnings may be volatile and there is no dividend or buybacks.