Dividend investing may seem a little intimidating at first, but it doesn't need to be. If you know what to look for and exercise a little discipline, you should be able to construct a rock-solid dividend stock portfolio.
Here are three principles to follow when picking dividend stocks that can help you separate the wheat from the chaff.
1. A healthy dividend is better than a big dividend
Perhaps the most important rule of dividend investing is that bigger is not always better. Just because a stock has a high dividend yield doesn't mean it's better than one with a lower payout. In fact, the opposite is often true.
Before buying a dividend stock, it's important to determine whether the current payout is sustainable, and the best way to do this is by looking at the company's payout ratio. Essentially, this is an expression of how much the company pays out to its shareholders versus how much profit it makes. A healthy dividend leaves enough profit left over for the company to reinvest in its business, raise the dividend in the future, and perhaps buy back some shares.
To calculate a payout ratio, divide a company's annual dividend by its trailing 12-month earnings. For example, a company that pays out $3 per share and earned $10 per share would have a payout ratio of 30%. I generally consider a "healthy" payout ratio to be 50% or less, but that's not a rule. Some companies can sustainably pay out 70% per more of their earnings. One prime example is real estate investment trusts, which are required to pay out 90% of their income in order to receive favorable tax treatment.
2. A growing dividend is the best kind of all
Perhaps the "Holy Grail" of dividend investing is a healthy dividend that will grow substantially over time. A steadily growing dividend can in time provide an income stream that you could live on, and you may be surprised how much annual dividend increases can compound over time.
There are many companies that increase their dividends like clockwork, which I'll get into in the next section. For now, let's look at an example of how rising dividends can affect your long-term performance.
Consider Coca-Cola (NYSE:KO), which has increased its dividend for 52 consecutive years. Over the past decade, the company has boosted its payout by an average of about 8.5% per year. So let's say you invested $10,000 in shares of Coca-Cola, which currently yields about 2.9%, giving you $290 per year in income from your investment. If the historical rate of dividend raises continues going forward, then in 20 years your shares will pay you about $1,500 per year, or 15% of your original investment. And your actual dividend income is likely to be significantly higher if you reinvest your dividends along the way.
As time goes on, this effect becomes even more dramatic. In fact, my grandmother owns shares of ExxonMobil (NYSE:XOM) that currently pay more in dividends than she paid for the shares in the first place!
3. History does repeat itself
Although the past can't always be relied upon to predict the future, that tends to be the case for dividend stocks. If a stock has a rock-solid record of increasing its dividend, then odds are that pattern will continue. Conversely, if a stock has a lousy record that includes dividend cuts, that may be a red flag that the dividend is vulnerable to dips in the market and the economy.
A great place to look for companies with excellent dividend histories is the Dividend Aristocrats, a group of elite companies that have all increased their payouts for at least 25 consecutive years. Not only do these companies provide an ever-increasing income stream, but many of them deliver consistent, market-beating performances.
For example, two of my favorites are Johnson & Johnson (NYSE:JNJ) and Colgate-Palmolive (NYSE:CL), which have delivered average annual total returns of 13.3% and 13.7%, respectively, over the past two decades, handily beating the S&P 500's 9.5% returns.
Now, it's important to mention that it is entirely possible for a Dividend Aristocrat to slash its payout if something catastrophic were to happen to the company. However, it's much less likely when a company has such a rock-solid history.
A good start
This is by no means an exhaustive guide on dividend investing, but these guidelines can steer you in the right direction as you set out to find the best dividend stocks on the market. Always do your homework when choosing which stocks to invest, and you could set yourself up for big gains with low risk.
Matthew Frankel has no position in any stocks mentioned, but his grandmother owns shares of ExxonMobil. The Motley Fool recommends Coca-Cola and Johnson & Johnson. The Motley Fool owns shares of Johnson & Johnson and has the following options: long January 2016 $37 calls on Coca-Cola and short January 2016 $37 puts on Coca-Cola. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.