Optimizing Dividends

If you're at least as stock-savvy as I am, you probably know these three things about dividends:

• Seeking out stocks that pay significant dividends can help make you rich.
• Choosing dividend-paying companies that have increased their dividend payouts significantly in the past is even better.
• Dividend yields rise when stock prices fall, and vice versa. (The dividend yield is calculated by dividing a company's annual dividend by its current stock price. It's a simple fraction, with the dividend on top and the stock price on the bottom. So as the stock price falls, the yield becomes bigger, and as the price rises, the yield shrinks.)

We may know these things, but we don't always consider them as a whole. We may get excited by a stock with a steep dividend yield, for example, but fail to look into its history of increasing that dividend. That oversight could be a mistake, because If you're looking at two companies -- say, one with a 2% yield and one with a 4% yield -- the former company might increase its dividend regularly and considerably, while the latter company might rarely raise it at all and may even reduce or eliminate it, as Washington Mutual (NYSE: WM) and Citigroup (NYSE: C) had to do recently.

We may also forget that yields fluctuate, a lot. In these days of considerable market turbulence, especially with lots of companies seeing their stock prices fall sharply, dividend yields are popping up all over the place. We need to remember that if we're looking for dividend investments, this is a particularly promising time to do so.

To see what I mean, imagine that Scruffy's Chicken Shack (ticker: BUKBUK) pays a $2 annual dividend ($0.50 per quarter) and sports a stock price of $60. If so, its dividend yield is 3.33% (That's $2 divided by $60.) Look how the yield changes as the price falls (with the dividend of $2 holding steady):

It's true that if you buy 100 shares at any of these prices, you'll receive no more or less than $200 in dividends yearly from Scruffy's. But that income will be costing you a lot less when you buy your shares at $40 instead of $60. Thus, your yield, the income you receive relative to the price you paid -- will be higher. 

Focusing on growth
Over at seekingalpha.com, I read a piece by Keith Lefebvre that discussed a Fool article on dividend yield dynamics. Adding his own thoughts on the importance of dividend growth rates, he said he seeks out companies growing their dividends by 8% to 12% annually -- and he made the good point that earnings need to grow at a similar rate, too, for the dividend growth to be sustainable.

Then he listed some companies that have current dividend yields higher than their historic averages and have also significantly raised their dividends. Here are a few of them, along with their 10-year dividend growth rates.

There's more
There's even more to consider, if you want to make the most of your investments in the world of dividends. For example, when evaluating investment candidates, you'd do well to consider each company's situation. Look at the financial health and competitive position of each one. Dividends aside, does its future excite you? Is its stock fairly or attractively priced? If you can find some companies that look like terrific investments even when you close your eyes to their significant dividends, then you may be looking at profiting from a powerful one-two punch: capital appreciation and dividend income.

So as you scour the stock universe, looking for companies that could make you comfy in your old age, look at all aspects of their dividends. Aim to take advantage of rising yields when stock prices fall, and consider the overall health and promise of the companies, too. After all, sometimes a 10% yield is steep only because the stock price has plunged because of some long-term crisis.

We'd love to help you find some dividend winners. I encourage you to take advantage of a free trial of our Motley Fool Income Investor newsletter service, which is outperforming the S&P 500. There's no obligation, and you'll be able to access all past issues and read up on every recommendation in detail. (Last time I checked, there were more than 20 recommendations with dividend yields topping 6%!)