Should You Buy the 3 Highest-Paying Dividend Stocks in the Dow Jones?

All that glitters is not gold. You've heard that saying before, I'm sure, but you may not appreciate how well it applies to stock dividends.

When looking for stocks to fill your portfolio, you would be wise to give heavy consideration to dividend-paying stocks. But a common error is to simply seek the fattest dividend yields. That's actually not always going to lead to the biggest long-term payouts for you, and it might even turn out to be a very regrettable move.

Image source: Getty Images.

What dividends are

Before delving into caveats about focusing on, say, the highest-yielding stocks in the Dow Jones Industrial Average, let's review what dividends are.

Most companies aim to grow and have ever-increasing profits. They often need to spend some or much of their income to further their growth -- such as by hiring more workers, buying more advertising, developing new products, and so on. They may also need to use money for other purposes, such as paying down debt. When a company's management feels that it's generating more money than it needs to spend, it may decide to reward (or attract) shareholders by committing to paying a regular dividend.

The beauty of dividends

Dividend-paying stocks can be terrific wealth builders for several reasons:

• Healthy and growing companies tend to increase their payouts over time, often annually.
• Healthy companies will tend to keep paying their dividends whether the economy is booming or struggling.
• Dividends shareholders receive can be reinvested in more shares of stock, each of which may pay dividends of its own, generating a compounding effect.
• Healthy and growing dividend payers will tend to have stock prices that rise over time, too, further enriching shareholders.

Now imagine that you've amassed a stock portfolio worth $400,000 with an average overall dividend yield of 3%. That means you can expect $12,000 to flow to you annually -- a sum very likely to increase over time. That's $1,000 per month -- to invest in more stocks or help support you in retirement -- all without requiring the sale of any stocks.

How dividends work

Dividends are typically viewed in terms of their "dividend yield," which is simply the sum of a year's dividend payments divided by the current stock price. It's essentially a fraction, expressed as a percentage. For example, imagine the Home Surgery Kits Co. (ticker: OUCHH), paying four quarterly dividends of $0.50 per share and trading for about $50 per share. Four times $0.50 is $2.00, and that divided by $50 is 0.04, or 4%:

$0.50 x 4 = $2.00

$2.00 / $50 = 0.04

0.04 = 4%

This means that a company's dividend yield will rise if dividend payments are increased and/or if the stock price falls. Imagine the stock price falls in half, to $25:

$0.50 x 4 = $2.00

$2.00 / $25 = 0.08

0.08 = 8%

Making sense of high dividend yields

You can probably see where I'm going with this math by now. When you see a fat dividend yield, even though you may be thinking to yourself that you'd love to be collecting 8% of your investment every year in cash, don't take any action before doing some digging.

At sites such as finance.yahoo.com, you can not only see a stock's current dividend amount and yield, you can also look up its dividend history to see if the payout has been rising or dropping. At yahoo.com -- and also sites such as Fool.com -- you can see the company's stock-price history. If the price has dropped significantly, that can explain why its dividend yield is hefty -- and it means you need to find out whether the company is facing any temporary or lasting challenges.

The highest yields in the Dow Jones Industrial Average

The Dow Jones Industrial Average has 30 companies in it, and here are the three with the highest recent yields. Let's take a look at some of them.

Source: Dividend.com.

Walgreens has a fat yield because its stock is down close to 40% year to date, and that's because Walgreens is struggling. It's investing in building out its healthcare business. It's also facing tough competition -- not only from CVS Health but also Amazon.com and Walmart -- carrying a lot of debt, and has a new CEO who hasn't been on the job for a month yet. Walgreens might do terrifically in the future, but its present is murky, and it's very possible that it will trim its dividend.

Verizon appears to be in better shape than Walgreens, but it's carrying even more debt (recently more than $130 billion) -- though it's been gradually paying that down. Some see the stock as a bargain, while others worry about its spending on its 5G network and see a possible dividend cut in the future.

3M, meanwhile, has seen its stock fall roughly 20% year to date, and has been facing various challenges. Some have been legal, with the company on the hook to pay $16 billion to $18 billion in settlements over the coming year. 3M is also about to spin off its healthcare business, which has been a major revenue grower for it. All this means its dividend may be in trouble.

Clearly, investing in the Dow's top yielders doesn't look like a reliable recipe for success. (Doing so has been a somewhat profitable venture in the past, though. If you're curious, read up on the "Dogs of the Dow" approach.)

Finding the best dividends

While you might think twice before investing in some ultra-high-yield stocks, know that some others can be genuine good values. Remember, too, that you should look beyond the yield to find great dividend payers: Look at the health and growth prospects of the company and also at the dividend growth rate. A stock yielding 3%, for example, might be a smarter buy than one yielding 4%, if the 3%-er has been hiking its payout more aggressively.