It can be hard to save money regularly so that you can buy shares of stock regularly -- so that you can build some financial security for your future. It's hard -- but it's also very important to do.
One way to make it easier is to park a bunch of healthy and growing dividend-paying stocks in your portfolio. Do so, and each quarter you'll see that your account's cash balance is higher than before. You'll be accumulating cash in your account without scrimping and saving (though for best results, continue saving) -- cash that can be deployed into more shares of stock whenever you're ready to make a purchase.
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Here are five dividend investing tips that can help you get the most out of dividends.
No. 1: Be wary of extra-steep yields
Let's start with dividend yields. It's natural to want to seek the highest yields you can find, but while some high yields reflect companies generating a lot of cash that they have no better use for, many other high yields reflect companies in trouble. That's due to simple math, because a dividend yield is a simple fraction, with a company's annual dividend sum divided by its current stock price. If a struggling company sees its stock price plunge, that will boost its yield -- until, perhaps, it has to reduce or eliminate its payout. The table below reflects how the math works:
|
Annual Dividend |
Stock Price |
Dividend Yield |
|---|---|---|
|
$1.00 |
$10 |
10% |
|
$1.00 |
$20 |
5% |
|
$1.00 |
$30 |
3.3% |
|
$1.00 |
$40 |
2.5% |
|
$1.00 |
$50 |
2% |
Data source: calculations by author.
Imagine you're looking at a company with a whopping 10% yield. Well, it may have been a company with a 3.3% yield a few weeks or months ago, before its stock price fell from $30 per share to $10. If the company is in real trouble, it might cut its payout to, say, $0.20, in which case its yield will suddenly be just 2%. If it suspends or eliminates its payout, that yield becomes 0%.
You don't have to ignore steep-yield stocks, but dig into them extra deeply, to see if they're facing any troubles. At a minimum, look at a chart of their stock price over the last year or two, and see if it has plunged. Regardless of the yield, though, you should be learning a lot about any company you invest in, so that you can be confident about its health and growth potential.
No. 2: Focus on dividend growth
Next, be sure to pay much attention to a dividend's growth rate along with its yield. All things being equal, a promising company with a 3% yield will be more attractive than a promising company with a 2% yield. But if that 2% dividend is being increased regularly by double-digit rates while the 3% dividend hasn't been increased in several years or is simply growing at a much lower rate, the 2% yield may end up delivering a lot more value in the years to come.
No. 3: Pay attention to the payout ratio
Understand what a payout ratio is, and check the payout ratio of any dividend-paying stock of interest. The payout ratio takes the current annual dividend amount (which is often the sum of four quarterly dividend payments) and divides it by the trailing 12 months' earnings per share (EPS). So if a company pays $2.00 annually in dividends and its EPS is $2.20, its payout ratio is $2.00 divided by $2.20, or 91%. That means the company is paying out 91% of earnings in dividends -- which can be OK, but it gives the company less flexibility to spend money on other things, and if earnings fall, dividends may be threatened. Thus, the lower the payout, the better, as low ratios mean that dividends are very manageable -- and have plenty of room for growth. A payout ratio of more than 100%, meanwhile, is not sustainable over the coming years.
No. 4: Reinvest your dividends
It's also smart to reinvest those dividends you receive. You might simply do it by letting dividend income accumulate in your investment account until you spend it now and then on additional shares of stocks you own or on shares of a new company you're adding to your portfolio. Alternatively, see if your brokerage will automatically reinvest your dividends for you, as many good brokerages will do. This calculation offered by the folks at the Hartford Funds earlier this year explains why reinvesting dividends is so valuable: "Going back to 1970, 78% of the total return of the S&P 500 Index can be attributed to reinvested dividends and the power of compounding."
No. 5: Low yields can be OK
Finally, while fat dividends from healthy and growing companies are hard to beat, it can also be fine to invest in companies offering low-yielding dividends. For one thing, those payouts may grow over time, and possibly substantially, if the company keeps getting bigger, generating more and more income. But even if the payout remains modest, if it's a relatively fast-growing company, its stock will grow over time -- possibly at a much faster rate than the overall stock market -- and you can enjoy dividend income along with stock-price appreciation.
However you go about it, it's smart to include some dividend payers in your portfolio -- and maybe even a lot of them. If you end up with a portfolio of dividend payers worth about $400,000 one day and its overall yield is 3%, you're looking at $12,000 in annual income!
