Dividends are the unsung heroes of investing, powerfully helping our portfolios grow while often being dismissed as boring. Many people don't appreciate just how powerful they can be, so check this out: Between 1960 and 2017, reinvested dividends accounted for about 82% of the total return of the S&P 500 index, as per The Hartford Funds.
It's smart to include dividend-paying stocks in your portfolio, but don't jump into them without reading up on and understanding them first. You may be drawn to the highest dividend yields you can find, but that can lead to trouble. Here are five things you should know about high-yield dividend stocks.
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No. 1: A big dividend yield can mean a bargain stock
First, a little math lesson. A key thing to understand about dividends and dividend yields is that a company's dividend yield is really just a simple fraction: It's the total annual dividend divided by the stock's current price. So if a stock pays out $0.50 per quarter, or $2.00 per year, and is trading for $40 per share, you'd divide $2 by $40 and would get 0.05, or 5%. That's the dividend yield. It reflects the fact that if you spend $40 on a share of the stock, you'll get 5% of your investment back in the form of a dividend.
Next, a company's dividend tends to remain unchanged for at least a year. Many companies increase them annually, while others can leave them unchanged for years. But a company's stock price will be changing all the time -- up and down, up and down, sometimes a lot, sometimes a little. That means that the dividend yield will also change all the time -- and most importantly, it means that when the stock price falls, the yield will rise, and vice versa.
If we go back to the example of the company with a $2 annual payout, imagine that its shares fall in value from $40 to $30. Divide $2 by $30 and you'll get a yield of 0.067, or 6.7%. The share price fell and the yield rose.
Thus, when you see a high-yield stock, it often means that the share price has fallen, pushing up its yield. So high yields can be indicators of bargain-priced stocks. But they can also suggest something else.
No. 2: A super-high dividend yield can indicate trouble
A fat dividend yield can also reflect a company in trouble. A company's challenges can push the stock price down, which, in turn, boosts the yield. That's not a big problem if these problems are temporary, such as a factory fire delaying production or an inability to keep up with demand due to an insufficient workforce. In such cases, you might snap up some shares and eventually profit from their rebound, while collecting the dividend.
But many times, a company will be facing serious, lasting problems, such as new, deep-pocketed competition, a major accounting scandal, or a high cash-burn rate. In such cases, a company may have to reduce or even eliminate its dividend, and even if it doesn't, its stock price could fall further, hurting investors. High-yield stocks demand some due diligence by would-be investors.
No. 3: A fat dividend may be tied to a more complicated security
It's also important to understand that there are different kinds of dividend-paying securities. Most of the time, it will be an ordinary public company offering a dividend payout. But sometimes, you'll be looking at a real estate investment trust (REIT), a company that owns lots of properties and collects lease payments from them. In exchange for some favorable tax treatment, REITs must pay out at least 90% of their income as dividends, so they do tend to sport generous yields.
Then there are preferred stocks, which work a little differently than common stock. They tend to appreciate more slowly but will pay out more in dividends. And should the company enter bankruptcy, they'll be ahead of common stockholders when any remaining assets are distributed.
Master limited partnerships, or MLPs, are another kind of security that tend to have hefty dividend yields. They have a certain kind of legal structure that permits greater cash flow, but come tax time, MLP dividend income can be taxed at higher rates than ordinary dividend income and you'll likely need to receive and report a K-1 tax form, too. Be sure to read up on any special kind of stock you're interested in.
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No. 4: All dividends need to be sustainable
It's great if you find a delightfully large dividend yield tied to an appealing business, but don't assume that all is good based on that information alone. You need to be sure that the dividend is sustainable -- and ideally, that it has room for growth. Enter the payout ratio.
The payout ratio is simply the amount of the company's annual dividend divided by its annual earnings per share (EPS). If a company is paying out $2 annually in dividends and its EPS over the past year is also $2, that's a payout ratio of 100%, meaning that the company is paying out all its earnings as dividends. That can seem great, but it gives the company no breathing room if earnings shrink or it wants to do something else with that money, such as hire more people, buy more advertising, or buy another company. Ideally, a company will have a payout ratio near or below, say, 60% or so. Be wary of ratios near or above 100%.
Cast an eye at the company's cash flow, too, because earnings per share are more of an accounting-based measure and can be manipulated more than cash flow. Ultimately, a company's dividend payments are coming from its cash flow, so you want to see ample flow. In some cases, a payout ratio may be steep, but a look at cash flow will be reassuring.
No. 5: Dividend growth is important, too
Don't just seek big yields. Yes, all things being equal, the bigger the yield, the better. But all things are rarely equal. So when you're seeking dividends for your portfolio, favor solid dividend growth.
Imagine, for example, two companies: ABC Inc. and XYZ Co. ABC has a fat yield of 6%, while XYZ is only yielding 3%. ABC might seem like the better investment, but if its payout is growing very slowly, while XYZ's payout grows briskly, XYZ's payout and dividend yield might outstrip ABC's over the long run.
In case you're not yet convinced that dividend growth really matters, consider this: The folks at Ned Davis Research studied the dividend payers in the S&P 500 index from 1972 through 2017 -- a whopping 46 years. They found that, while the overall index averaged annual gains of 7.7% during that period, dividend payers averaged 9.25%. They also found that it wasn't just enough to pay a dividend: Dividend payers that weren't busy upping their payouts only averaged 7.5%, while those companies that either started paying a dividend or boosted it regularly averaged 10.1%.
Here are some familiar dividend payers and their recent five-year dividend growth rates:
|
Stock |
Recent Dividend Yield |
Five-Year Dividend Growth Rate |
|---|---|---|
|
Apple |
1.7% |
9.2% |
|
Verizon Communications |
4.5% |
2.6% |
|
Boeing |
2.03% |
23% |
|
Starbucks |
2.1% |
6.7% |
|
Microsoft |
1.7% |
10.4% |
|
3M |
2.9% |
16.5% |
|
Pfizer |
3.4% |
6.7% |
Source: Yahoo! Financial and author calculations.
Armed with the information above, go ahead and consider adding dividend-paying stocks to your portfolio. Don't be afraid of ones with very high yields, but take a closer look at each such contender to see why its payout is so rich -- and favor dividends that are being increased regularly and significantly.
