Dividend Investing -- It's Not Just for Retirees

What is dividend investing, and why buy dividend stocks? Well, dividend stocks can provide valuable long-term income and deserves a spot in your investing strategy. Once you learn what dividend investing can do for you, you may well want to be a dividend growth investor.

Image source: Getty Images.

What is dividend investing?

Here's a quick review of what the strategy of dividend investing involves. As you know, solid companies feature both revenue on their top lines and earnings on their bottom lines, and ideally, both will grow over time. What do they do with that money? Well, many invest it back into the company, hiring more people, building another factory, buying more advertising -- or even buying another company. They may pay down debt, too, or buy back shares. Not every company needs to allocate every available dollar to furthering growth, though. Bigger, more established companies often have more cash than they have good uses for -- enter dividends.

By paying out a portion of their earnings to shareholders, companies reward shareholders and help retain many. After all, stocks don't go up in straight lines, and both companies and the overall market go through slumps. The beauty of a strong company's dividend is that even during downturns, the dividends will likely keep getting paid out. Your stock may stall or go south for a while, but you'll still be profiting.

Image source: Getty Images.

Why engage in dividend investing?

One thing that dividend investing is not is something that's suitable only for conservative retirees. That's because dividend-paying stocks tend to outperform their payout-free counterparts. Researchers Eugene Fama and Kenneth French, studying data from 1927 to 2014, found that dividend payers outperformed non-payers, averaging 10.4% annual growth vs. 8.5%. According to data from the S&P Dow Jones Indices, dividend income made up 33% of the monthly total return of the S&P 500 between 1926 and 2015. Even better, dividend-paying stocks are considerably less volatile than non-payers, too.

That's pretty powerful data. If you think the difference between an 8.5% growth rate and a 10.4% one isn't that great, check out the following tables:

Here's how a one-time $10,000 investment would grow:

Calculations by author.

And here's how an annual $10,000 investment would grow:

Calculations by author.

Clearly, seemingly modest differences in growth rates can result in wildly different results over many years.

What stocks pay dividends?

The range of companies paying dividends is enormous. There are, of course, big, established blue-chip companies, such as the following:

Data source: Yahoo! Finance.

But you'll also find more dynamic, potentially faster-growing companies among dividend payers, as well:

Data source: Yahoo! Finance.

Even some smaller companies, such as gun maker Sturm, Ruger, pay dividends. (It recently yielded 3.3%.)

Image source: Pixabay.

Dividend investing tips

Don't just jump at any familiar dividend-paying name, though. Be sure to focus on high-quality companies with sustainable competitive advantages and great growth prospects. You'll also want them to be attractively valued, since paying too much for a great company isn't a recipe for success. When it comes to the dividend, though, focus on the yield, the dividend growth rate, and the payout ratio.

A dividend yield is calculated by taking the current annual dividend amount and dividing it by the current stock price. So, if a stock craters, that will send its yield zooming skyward. Thus, be wary of especially attractive yields, because they may be tied to a stock in temporary or long-lasting trouble.

If you're looking at two or more solid dividend payers, don't just choose the ones with the fatter yields -- because if you're planning to hang on for years, the dividend growth rate can make a big difference. A 2% yield might not seem that exciting today, but if the company has increased its payout by an annual average of 10% over the past five years, and you expect that to continue, in a decade, its effective yield will top 5%. Thus, if Company A's yield is smaller but faster-growing than that of Company B, it may be the better choice.

Next, check out a dividend-payer's payout ratio, which shows the portion of earnings being paid out in dividends. Clearly, a payout ratio of 100% or more would reflect a company without much wiggle room and with little likelihood of hiking its payout anytime soon. So, it can be smart to favor companies with low or reasonable payout ratios, such as, perhaps, 75% or less. Don't be too rigid about it, though. A company might have a payout ratio of 120%, but only because it had an uncharacteristically bad year. If it's expected to post strong earnings soon, you might worry less about the high payout ratio.

Consistency is a good sign. If a company has been paying a dividend without interruption for, say, 50 years, it's going to take that streak seriously and will want to keep it going. If a company has consistently grown its top and/or bottom line, that can be a sign of effective management and the ability to keep paying dividends.

Dividend investing is a great way to build your wealth. Give it serious consideration.