One of the best ways to make a lot of money in stocks is to invest in dividend-paying stocks. After all, a company that is able to commit to regularly rewarding its shareholders with a payout of cash is a company that's relatively stable, with a sufficiently predictable profit stream. There are pitfalls within the world of dividend investing, though. Here are some tips to help you avoid common blunders.
It's easy to be drawn to sky-high dividend yields. Who wouldn't favor a 10% yield over a 3% one, after all? Plenty of 10% yields are solid, but plenty are tied to companies on shaky ground. The best explanation for that is math: A dividend yield is simply a ratio, dividing a stock's annual dividend payout by its current stock price, and then expressing that result as a percentage. Thus, if the stock price falls sharply, you'll be dividing the dividend by a smaller number, and the yield will be bigger. Huge dividend yields are sometimes due to a company simply having a lot of excess cash to distribute, but sometimes they reflect a company in temporary or permanent trouble that has seen its price plunge.
A good dividend investor needs to remember that dividend amounts are not set in stone. Companies do try hard to not reduce or eliminate them, but that happens sometimes. Recently, for example, both Atlantic Power (NYSE:AT) and Exelon (NYSE:EXC) reduced their dividends -- by 65% and 40%, respectively. Atlantic had been yielding 10%, and Exelon 6.8%. Atlantic still sports a hefty yield, but that's because its stock has fallen some 62% over the past three months amid poor results and worries over lawsuits. Exelon, a nuclear-power specialist, is viewed more favorably, and has been investing in renewable energy, as well. Still, some think it could be a while before its also-depressed stock turns around.
Pay attention to payout ratios
It's smart to examine a company's payout ratio, too. That measures the percentage of its earnings that it's paying out in dividends. Clearly, a company paying out more than 100% of its earnings for a protracted period is not in a sustainable situation. Telecom company Windstream (NASDAQ:WIN), for example, sports a fetching dividend yield above 11%, but its actual annual dividend of $1.00 annually is worrisome, given its trailing 12 months of earnings per share of just $0.28. Sure, earnings can rise and make this less worrisome, but it's definitely a red flag worth considering. Bulls are hopeful about its acquisitions, but it also carries a lot of debt.
Seek dividend growth
Another important thing a good dividend investor does is to factor in dividend growth along with dividend size. If you're looking at two companies, each with a 3% dividend yield, but one has been growing its payout by 10% annually, while the other has averaged just 2%, it's clear that one is more attractive. You don't always have to choose one or the other, though. Australia-based oil, gas, and mining giant BHP Billiton (NYSE:BHP), for example, recently yielded a solid 3.6% and sported a five-year average dividend growth rate of 14.5%. The company has a new CEO intent on cutting costs and boosting productivity, and he's even cutting his own salary. Corning (NYSE:GLW), meanwhile, recently yielded 2.8% and sports a five-year average dividend growth rate of 14.9%. Its stock just jumped on a solid earnings report, featuring moderating LCD glass price declines, and growth in its Gorilla Glass.
Choose high-quality companies
It's also vital to focus on high-quality companies, if you want to be able to sleep at night as a dividend investor. Remember that big and boring companies can do wonders to your portfolio with their dividends, especially if they're steadily growing and aren't overtaking earnings. Look for companies that feature businesses you understand, competitive strengths (such as a strong brand or economies of scale), solid growth prospects, and a healthy balance sheet, among other things. Perhaps even seek out the most promising companies you can find first -- and then check out their dividends.
Finally, don't be in a rush. Dividends growing at 10% or 20% annually are a beautiful thing, but they won't deliver riches in their first few years. Aim to hold on for many years, as long as the companies remain promising and healthy and growing. A dividend investor who's doing it right will simply have a stable of solid dividend stocks paying you cash quarter after quarter, year after year -- in increasing amounts. (That said, do not hold forever if a company starts seeming shaky.)
Longtime Fool contributor Selena Maranjian, whom you can follow on Twitter, owns shares of Corning and Windstream. The Motley Fool recommends Corning and Exelon and owns shares of Corning. Try any of our Foolish newsletter services free for 30 days. We Fools don't 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.