If you own individual stocks, it's generally a smart idea to own at least one dividend-paying equity. The main reason is that dividend stocks with yields below the average of the S&P 500 index, which stands at 1.62% at present, frequently deliver above-average returns on capital on a multiyear basis. Alternatively, stocks with yields above the S&P 500 average can serve as powerful hedges against market volatility, and provide healthy levels of income over time. Like any investment, though, you should have a clear idea about how a dividend stock fits into your broader strategy and overall portfolio before buying shares.
So why buy a dividend stock? Dividend stocks can serve one of two mutually exclusive roles in a portfolio: capital appreciation or income generation. On the capital appreciation side of the ledger, you want to own stocks with fairly low annualized yields, strong and sustainable earnings power, a premium valuation, and, related to this last point, clear-cut forward momentum in terms of its share price over the prior five-year period. By contrast, stocks suited for the income generation bucket should sport sizable yields, sustainable payouts, healthy free cash flows, a bargain-basement valuation, and relatively low share prices. More on this underappreciated point later.
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With this brief background in mind, let's walk through two empirical examples to illustrate the differences between capital appreciation and income-generating dividend stocks.
Nvidia: A minuscule dividend, but spectacular growth
Nvidia (NVDA 6.18%) is a leading company in the semiconductor and artificial-intelligence industry. It started paying dividends to its shareholders in November 2012. However, its dividend has not been a priority for management, as evidenced by the decreasing payout over the last 10 years. In fact, the current dividend yield is only 0.03%.
Nevertheless, Nvidia stock has provided amazing returns on capital that are hard to match. Since launching its dividend program, the stock has soared by a staggering 15,960%. Nvidia's performance in this period follows the aforementioned criteria for dividend stocks as sources of capital appreciation.
Specifically, it has consistently had a low dividend yield, its earnings per share have steadily increased over the past several years, it has often been one of the market's most expensive stocks, and its stock price has churned higher over a multiyear period. Now, Nvidia's stock was already a winner before it initiated its dividend program, but most of its explosive growth has actually occurred during its years as a dividend payer.
NVDA Total Return Level data by YCharts
What's more, the majority of top-performing dividend stocks over the past 10 years closely conform to the criteria we've outlined -- especially those with market caps above the $10 billion mark. Nvidia, in effect, is far from an outlier in this regard.
AT&T: An income stock with a built-in safety net
Telecom giant AT&T (T 1.02%) has been on a multiyear losing streak, thanks to the fierce price competition among the big three U.S. wireless carriers over the prior two decades. Underscoring this point, the company's shares have fallen by nearly 40% over the past 10 years. That's terrible, and there's no way to sugarcoat it. Worse still, AT&T isn't expected to be a bastion of growth anytime soon. Ignoring this stock, though, may be a mistake by the income crowd. Here's why.
As a result of its plunging share price, AT&T's stock now trades at one of the cheapest valuations in its operating history, and its annualized dividend has swelled to a noteworthy 6.84%. So it immediately ticks two of the key criteria for income stocks we've listed -- bargain-basement valuation and above-average yield. Where things get truly interesting, though, is in the company's improving fundamental picture.
With a fair amount of its large capital expenditures out of the way and the U.S. wireless market starting to stabilize from a price point, AT&T's free cash flows are forecast to rise substantially over the next 12 months. That fact bodes extremely well for the sustainability of the company's dividend program. Moreover, its trailing-12-month payout ratio of only 55.8% further indicates that its quarterly distribution ought to be sustainable for the foreseeable future. Hence, AT&T ticks off another important box in the income-generation bucket.
However, the best part is arguably AT&T's relatively low share price. At $16.21 as of this writing, it takes only $1,621 to buy an allotment of 100 shares, which can then be used as part of a covered call strategy to further enhance the stock's income-generation capabilities. Dividend stocks with high share prices require greater amounts of capital to tap into this income generation strategy, which isn't necessarily a bad thing, but it limits the types of investors that can participate in this multipronged approach to income generation.
In all, AT&T's rock-bottom valuation ought to serve as a safe haven for income seekers in today's volatile market environment. The company has a solid track record of rewarding shareholders with generous dividends, and its improving cash flow situation should allow it to maintain or even increase its payout in the future. Its low share price also offers an opportunity to leverage a covered call strategy to boost its income potential even further. Therefore, AT&T screens as a compelling income-generation stock.
