The power of investing in dividend-paying companies is underappreciated by many people. That's a shame, because it means that their portfolios may not be performing as well as they could, and they may end up amassing less wealth than they could. The tips below can help you make the most of dividend-paying stocks.
- You can start with very little. Many people think they can't or shouldn't start investing in stocks until they have a lot of money saved up, such as several thousand dollars. That's wrong -- especially for dividend payers, because dividend reinvestment plans ("Drips") and direct investing plans, offered by hundreds of companies, let you buy shares and fractions of shares of stocks with small sums, such as $25 or $50.
- Only invest money you won't need for five to 10 years. With dividend payers and non-payers alike, keep any money you'll need in the relatively near future away from them. That's because over a few years, the stock market can plunge, or just stagnate. If the account where you're saving for a down payment that you will need soon suddenly falls in value by 20%, your homebuying plans will be in peril.
- Save aggressively and invest regularly to build wealth. You can make big money in stocks, or at least build a comfortable retirement, but only if you're serious about it. Invest, say, $8,000 per year for 25 years, and if you earn an annual average return of 8%, you'll end up with more than $630,000!
- Look at the dividend yield, not the dividend amount. If one company has a quarterly dividend payment of $0.60 and another's is $1.00, don't make the mistake of thinking the $1.00 dividend is better. Focus on the dividend yield instead, which is the current annual dividend amount divided by the current stock price. The $0.60 dividend might be yielding 2.4%, vs. just 0.9% for the $1.00 dividend. It all depends on the stock price. (This math is also why dividend yields jump when a stock price falls, and vice versa.)
- Favor bigger yields over smaller ones -- in general. Of course, a bigger yield is better than a smaller one, all things being equal. But all things are not always equal. Be sure to take into account the company's health and prospects and how well it's doing.
- Be wary of huge yields. Sometimes a really big dividend yield indicates a company in trouble, not a company that's especially generous with its excess cash. Remember that the dividend yield can be thought of as a fraction, with annual dividend amount divided by the current stock price. Thus, if the stock price drops, the yield will get bigger. Big yields sometimes reflect stocks that have crashed and are on shaky ground. Definitely take a close look at any such contender.
- Seek strong dividend growth. It's valuable to assess a stock's dividend history, too, not just where its payout is now. Ideally, you want it to be increasing its dividend regularly and significantly. A stock yielding 2% could be more attractive than one yielding 3% if it's growing its dividend much more briskly. In a few years, it could be yielding more.
- Check the payout ratio. A dividend payer's payout ratio is also important. It reflects the portion of earnings that's being paid out in dividends. If it's, say, 70% or less, there's room for continued dividend growth. If it's 100% or more, there's no room for growth -- or error -- and perhaps the dividend will even end up reduced.
- Understand effective yields. It's good to understand what an effective yield is, too. Imagine, for example, that you buy shares of Scruffy's Chicken Shack (ticker: BUKBUK), which is trading at $100 per share and pays $4 in annual dividends, for a yield of 4%. If it hikes its payout by 7% for a decade, that $4 annual dividend will become $7.88. If you're collecting $7.88 per share for shares you bought for $100, that's an effective 7.8% yield for you.
- Remember that there's a real company behind each dividend. Never think of any shares of stock as lottery tickets or as bets on a company. Remember that each one is tied to a real company, and that you're a part owner in it -- ideally for a long time.
- Be sure you understand the companies you invest in. Don't invest in companies you don't understand, lest you end up blind-sided when they run into trouble. Make sure you know exactly how they make their money.
- Seek high quality companies. Focus on high-quality companies, with characteristics such as sustainable competitive advantages, talented management, substantial and growing profit margins, increasing revenue and earnings, little or no debt, solid growth prospects, and so on.
- Invest in companies when they're attractively priced. When you find great companies, don't invest in them at any price. Wait until they're attractively priced. (It can help to maintain a watch list of companies of interest.) Knowing when they're undervalued is easier said than done, but as a rough guide, you might look for P/E (price-to-earnings) ratios below their five-year average, or PEG (price-to-earnings growth) ratios below 1.0.
- Know what tax hit to expect. Most dividends you'll receive from shares of stock will enjoy a relatively low tax rate. It's currently 0% for low-income folks in the 10% or 15% tax brackets, and 15% for most of us. Those in the highest tax bracket will face a 20% rate. If you hold your dividend-paying stocks in a traditional IRA or 401(k), you'll only be taxed when you withdraw funds from the account, but you'll face ordinary income tax rates on that income, which could be 25% or 28% for many of us. Of course, if you hold your dividend payers in a Roth IRA, you will likely pay no taxes at all!
- Invest for the long term. A key way to build great wealth is to park your money in high-quality long-term growers and to leave it invested for many years. Do follow and keep up with your holdings, because sometimes selling will make sense. But in general, be patient and aim to be a long-term holder.
- There's no shame in just sticking with index funds. If all this sounds like a lot of work, know that there's no shame in simply investing in an inexpensive, broad-market index fund or two. You'll roughly match the overall market's return, and you'll enjoy dividend income, too. The S&P 500, for example, was recently yielding about 2.1%.
- Keep learning. Finally, keep learning. The more you know about investing in general -- as well as business and your particular holdings -- the better your investment performance will likely be.
Longtime Fool specialist Selena Maranjian, whom you can follow on Twitter, owns no shares of any company mentioned in this article. 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.