Fools like you and me probably know at least three things about dividends:

  • Stocks that pay significant dividends can help make you rich.
  • The best such companies have increased their dividend payouts significantly in the past.
  • Dividend yields rise when stock prices fall, and vice versa. (The dividend yield equals a company's annual dividend, divided by its current stock price. As the stock price falls, the yield becomes bigger; as the price rises, the yield shrinks.)

We may know these facts in isolation, but we don't always consider them as a whole. It's easy to get excited about a stock with a steep dividend yield, for example, but fail to investigate how steadily that dividend has increased. A company with a 2% yield might increase its payout regularly, while one yielding 4% might rarely raise its dividend at all -- or even reduce or eliminate it, as Washington Mutual (NYSE:WM) and Citigroup (NYSE:C) had to do this past year.

It's also easy to forget that yields fluctuate widely and often. 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. That makes now a particularly promising time to seek dividend investments.

Calculating a stock's yield
For example, imagine that Scruffy's Chicken Shack (Ticker: BUKBUK) pays a $2 annual dividend ($0.50 per quarter) and sports a stock price of $60. That makes its dividend yield 3.33% -- $2 divided by $60. Assuming that $2 payout holds steady, look how the yield changes as the price falls:

Stock Price

Yield

$60

3.33%

$55

3.64%

$50

4.00%

$45

4.44%

$40

5.00%

$35

5.71%

$30

6.67%

If you buy 100 shares at any of these prices, Scruffy's will pay you no more or less than $200 in dividends every year. But that income will cost 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. Lefebvre added that he seeks out companies growing their dividends by 8% to 12% annually, and he noted that such stocks' earnings need to grow at a similar rate to keep that dividend growth sustainable.

Lefebvre then listed several companies with current dividend yields that have been significantly raised beyond than their historic averages. Here are just a few:

Company

Recent Dividend Yield

5-Year Dividend Growth Rate

Bank of America (NYSE:BAC)

7.7%

12.9%

Pfizer (NYSE:PFE)

6.4%

16.1%

General Electric (NYSE:GE)

4.1%

9.3%

United Parcel Service (NYSE:UPS)

2.7%

15.6%

Masco (NYSE:MAS)

5.1%

10.7%

Source: Seekingalpha.com, DividendInvestor.com.

Making the most of dividend investments
When evaluating investment candidates, consider each company's financial health and competitive position. Dividends aside, does its future excite you? Is its stock fairly or attractively priced? If you can find companies that look like terrific investments even without their payouts, you may be poised to profit from the powerful one-two punch of capital appreciation and dividend income.

So as you scour the stock universe, seeking companies that could make you comfy in your old age, look at all aspects of their dividends. Take advantage of rising yields when stock prices fall, but don't forget about the overall health and promise of the companies you evaluate. Sometimes a 10% yield is steep only because some lasting, long-term crisis has sent the stock price plunging.

A free trial of our S&P 500-beating Motley Fool Income Investor newsletter service can help you find your own slate of dividend winners. You'll be able to access all past issues and read up on every recommendation in detail, with no obligation to subscribe. (Last time I checked, more than 20 recommendations had dividend yields topping 6%!)

Anand Chokkavelu updated this article, originally written by Selena Maranjian and published on Jan. 25, 2008, and owns shares of Pfizer and Citigroup. United Parcel Service, Pfizer, Masco, and Bank of America are Motley Fool Income Investor picks. Pfizer is a Motley Fool Inside Value recommendation. The Fool's disclosure policy pays dividends every day.