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.

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, whereas the latter company might rarely raise it at all and may even reduce or eliminate it. In recent months, several companies, including KeyCorp (NYSE:KEY), Sotheby's (NYSE:BID), and International Paper (NASDAQ:IP), have slashed their dividends by 50% or more.

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):

Stock Price

Yield

$60

3.33%

$55

3.64%

$50

4.00%

$45

4.44%

$40

5.00%

$35

5.71%

$30

6.67%

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
Companies that have consistently growing dividends can be promising investments, as your dividend yield can go up even if the share price stays stable or grows slightly over time.

Here are a few companies with strong dividend yields and good dividend growth rates:

Company

Recent Dividend Yield

5-Year Dividend Growth Rate

PepsiCo (NYSE:PEP)

3.2%

19%

IBM (NYSE:IBM)

2.2%

26%

American Express (NYSE:AXP)

3.2%

13%

Caterpillar (NYSE:CAT)

5.5%

17%

Source: DividendInvestor.com.

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, but consider the overall health and promise of the companies, too. That's the best way to avoid yield traps and invest in strong companies.

For more on income investing, read about:

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This article was originally published on Jan. 25, 2008. It has been updated by Dan Caplinger, who doesn't own shares of the companies mentioned. PepsiCo is a Motley Fool Income Investor recommendation. Sotheby's is a Motley Fool Hidden Gems pick. Try our investing services free for 30 days. The Fool owns shares of American Express, which is a Motley Fool Inside Value selection. The Motley Fool is Fools writing for Fools.