Done well, dividend investing can be an incredibly rewarding experience. Done poorly, it can destroy your capital. These five dividend investing tips can earn you thousands as they can help you avoid some of the largest mistakes and focus your strategy on key factors typically linked with dividend investing success.
Tip 1: Think like Goldilocks when it comes to coverage
Key to successful dividend investing is to think a little bit like Goldilocks in that old fairy tale when searching for companies that pay dividends. If a company pays out too much in its dividend, it doesn't retain enough to sustain its operations and growth. If it pays out too little, it doesn't get the discipline benefits associated with having to come up with that cold, hard cash to pay its shareholders.
A general rule of thumb is to look for payout ratios between 25% and 75% of earnings for most businesses, though there are some industries like Real Estate where payouts are frequently higher. There's a particular risk in a dividend that's higher than the company can sustain -- the risk that the dividend will get cut. Dividend cuts are frequently accompanied by a decline in a company's stock price. That ends up being a double whammy for investors.
Tip 2: Look for growth and the underlying drivers of it
A big part of your ultimate success as an investor -- even a dividend-focused investor -- comes from the growth that successful companies achieve over time. A dividend-paying company that has a history of increasing its dividend and still looks to have legitimate growth prospects ahead of it is one that has the prospect of continuing to increase that dividend. If you're a shareholder in a company that increases its dividend, you will receive that income growth without investing another dime of your cash.
Key things to look for when it comes to considering whether a company has growth opportunities include:
- New product launches.
- New geographic locations.
- Rising customer counts and penetration rates.
- Pricing power.
- "Tuck-in" acquisitions in related industries -- especially if they're quickly accretive.
Tip 3: Remember that dividends are low priority payments
If a company is unable to pay its dividend, it can simply lower or suspend it. Sure, its stock price might drop, but unless a company is one of the rare corporate types that require dividend payments, there's typically no other real consequence for a company that cuts its dividend.
On the flip side, failure to make a bond payment -- either a coupon payment or to return the principal at maturity -- can trigger a default. If a company defaults on its debt, the consequences can be as severe as bankruptcy and 100% loss of the value of the company's common stock. Companies can -- and often do -- cut their dividend to protect their balance sheets to avoid those default risks.
As a result, dividend-oriented investors will want to keep an eye on how much debt their companies have, whether those debt loads are increasing over time, and how well those debt costs are covered. If the company's balance sheet is over leveraged or its debt coverage ratios start to suffer, its dividend may very well get cut to protect those far higher priority payments.
Tip 4: Use your dividends as a corporate malarkey detector
As wonderful as the income from a dividend can be, it serves an equally important role as a corporate malarkey detector. As the old saying goes, "Talk is cheap." If a company's leadership boasts of great growth to come but its dividend barely budges, chances are pretty good that the dividend is telling a more accurate tale of what its leadership really believes.
That's because dividends are typically made as cash payments. To make that payment, a company has to come up with the cold, hard cash. The most reliable source of dividend-ready cash comes from a company's operations, since lenders usually balk at companies that borrow money to make dividend payments. As a result, companies don't generally like to increase their dividends any farther than they really expect to be able to support from their operations.
Tip 5: Bigger isn't always better
While it's tempting to seek out high dividend yields to get the most back in income for every dollar invested, that can be incredibly risky. A company offering up a dividend yield that's substantially higher than the rest of its industry is frequently a sign of a dividend at risk of getting cut. If you look behind the yield to the fundamental numbers of an exceptionally high-yielding company, you're likely to find things like dividends in excess of cash flows indicating the real risks involved.
Instead of searching out the highest possible yield, look instead for dividends that:
- Are well covered (Tip 1),
- Have the opportunity to grow (Tip 2), and
- Are not at substantial risk because of a company's overleveraged balance sheet (Tip 3).
That combination will give you a great opportunity to turn your dividend investing strategy into one with a very strong chance of earning you some serious cash during your investing journey.
When all is said and done, your dividends can be an incredibly important part of your total investing return. By focusing on these five tips throughout your tenure as a dividend oriented investor, you have a strong shot of earning thousands -- potentially even more -- from the dividends you receive.