Dividend Investing: The 5 Do’s and Don’ts of Dividend Investing
Introduction to Dividend Investing
Ultra-low interest rates and a choppy, long-in-the-tooth bull market have made dividend investing tougher than ever.
For buy-and-hold investors, dividend growth stocks can provide a steady, increasing income stream and protect against short-term volatility. But the desire to create income in a low-growth environment can lead to long-term problems. Following some tried-and-true do’s and don’ts can make your dividend investing a lot more profitable.
Don’t Chase the Highest Dividend
The temptation with dividend investing is to find a company that provides a sky-high yield. With interest rates near zero and the average dividend payout on the S&P 500 at 2.1%, what’s not to love about a stock that provides an annual dividend of 15%?
A lot, actually.
When it comes to dividend investing, there is a risk/reward trade-off; the higher the dividend yield, the greater the risk. A 15% dividend yield may be tempting, but your capital is on the line. If the company runs into money trouble, the first thing to go will be the dividend, which could also kill the company’s share price.
Well known major companies like Altria Group Inc (NYSE:MO), The Coca-Cola Co (NYSE:KO), and Procter & Gamble Co (NYSE:PG) may only provide annual dividends in the three- to four-percent range, but they’re reliable companies with strong operations.
Again, for buy-and-hold investors, a big company that provides reliable dividend growth is a better option for long-term wealth than a new company that provides a sky-high dividend.
Do Understand the Company You’re Investing In
Investors with their eye on retirement might end up pouring their hard-earned money into a stock with a 15% dividend yield because they didn’t take the time to understand the company they’re investing in.
Earning income from a dividend stock might be a no-brainer, but you can’t invest in just any old high-dividend stock. Investors need to make sure the company they’re investing in is going to not only be around for years to come, but also remain financially stable enough to continue to make those dividend payments.
Investors need to understand the risks involved, especially if they’re investing for retirement. After all, dividends are only as safe and sustainable as the underlying strength of the company. That’s why investors need to analyze the financial strength of the company.
Do Study a Company’s Cash Flow Statement
Look at the company’s financial health, earnings outlook, and debt-to-equity ratio.
The total assets should be greater than total current liabilities; if so, the company will not run into any short-term cash-flow problems. A company that is running short on cash, on the other hand, will issue stock or sell off assets to support their dividend payments. These are not long-term growth strategies, nor are the dividends sustainable.
Be careful of companies that pay most of their profits out in dividends; if one is, future dividend payouts may be in jeopardy. That’s because the company isn’t retaining any money to reinvest back into the business to promote future growth. If the economy sours or the company hits lean times and its cash starts to dry up, the dividend, as previously noted, will be one of the first things that management cuts.
A good way to decide whether or not the company can maintain and build upon its annual dividend yield is to look at its free cash flow. This is the amount of money left over after capital expenditures.
Also take a look at the total payout ratio (dividends divided by net earnings). If a business has a payout ratio of 75%, chances are good that it isn’t putting much back into the company to make money.
But this isn’t totally cut and dry. This ratio does not apply to real estate investment trusts (REITs) or master limited partnerships (MLPs), which legally have to return the vast majority of profits to investors.
Lastly, look for stocks with a high barrier to entry. This prevents other companies from entering the fray and taking a bite out of profit margins, which ultimately keeps the company making money and the dividend yield safe.
Do Look for Companies with a History of Increasing Their Dividends
Reliable dividend payouts are great.
Finding companies that increase their annual dividend yields year-after-year is even better. Businesses like Altria, Coca-Cola, and Procter & Gamble have been around for a long time. They each have a huge international footprint and make money no matter what the broader economy is doing.
In addition to returning some of that money to investors in the form of dividends, these companies also raise their dividend yields annually. Altria, which pays an annual dividend of around 3.8%, has raised its annual dividend for 47 consecutive years, while Coca-Cola (3.3%) has raised its annual dividend for 54 years. Meanwhile, Procter & Gamble (3.1%) has been rewarding investors by raising its annual dividend for the past 60 years.
A company paying a 10% or 15% yield sounds enticing, but if you’re thinking about generating income that will help you in retirement, it might be a better idea to consider international companies that provide investors with regular, reliable dividend increases.
Why? It means that these companies will continue to grow their businesses and make money no matter what the economy is doing. Chances are also really good that the company will want to continue down this path. These are the type of businesses I like when dividend investing.
Don’t Cash in Your Dividends
It might be pretty tempting to take the dividend payouts in cash, but reinvesting the dividends can make a lot more sense for long-term investors. By reinvesting the dividends, you can purchase additional shares.
That also allows investors to harness the power of compound interest. A four-percent annual dividend is nice, but if reinvesting that dividend can help generate additional returns, potentially turning that four percent annual dividend into five or six percent or more.
A great way to take advantage of dividend growth stocks is to take advantage of the company’s dividend reinvestment plan (DRIP) and direct stock purchase plan (DSPP). This allows you to automatically reinvest your dividends. You can also purchase shares, fractional or whole, without needing to use a broker.
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