With even 30-year Treasury bonds only yielding around 2.3%,investors looking for income from their portfolios have to look farther out on the risk curve than government bonds to get decent yields. Those low yields are making stocks -- which often not only pay higher-yielding dividends but also have the potential to raise their dividends over time -- look that much more attractive by comparison.
Still, investing in dividend stocks requires much more than just looking for high yields. Indeed, searching for stocks just based on their yields is a great way to lose money, as the stocks with the highest reported yields are often ones most at risk of cutting their dividends. If you want a smarter way than just searching on yield to find income-producing stocks, these three dividend investing tips can help earn you thousands.
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No. 1: Look at the company's payout ratio
A company's payout ratio shows how much of its earnings it pays out in the form of its dividend. In most cases, what you're interested in is a payout ratio in the "Goldilocks" zone. Too low of a payout ratio, and it's often a sign the company either doesn't prioritize its dividend or that it feels its earnings are too volatile and at risk to justify a larger dividend. Too high of a payout ratio, and it's frequently a sign that either the dividend is at risk or the company is sacrificing growth opportunities to make the payment.
Where does that Goldilocks zone sit? Well, it depends in large part on what type of company you're investing in. For most standard companies, a payout ratio somewhere in the range of 25%-75% is reasonable. For a few specific types of specialized companies, such as real estate investment trusts and limited partnerships, a higher payout ratio may very well make sense. This is because those specialized companies follow tax rules that pretty much require high dividends.
Real estate investment trusts must pay out at least 90% of their qualifying income as dividends, and in exchange, they can "pass through" that income without paying a corporate tax on it.Similarly, the holders of limited partnerships are taxed on the partnership's earnings as their own income regardless of whether they receive it as cash. As a result, limited partnerships also tend to offer high yields. Even so, you'll want to make sure their dividends are covered by the business' cash flows before investing.
No. 2: Look for a history of dividend growth
Dividends are not guaranteed payments, and a company's board of directors generally sets its dividend based on the company's priorities and an expectation of its ability to pay it. If a company has a track record of boosting its dividend, it's a sign that its board is serious about directly rewarding shareholders for the financial risks they're taking by investing in the business. It also means that if things go well, there's the chance the dividend could be increased again in the future.
On top of the direct cash rewards that come from an adequately covered and expanding yield, a growing dividend can also signalwhat the company's management really thinks. After all, companies that cut their dividends often also see their share prices tank, so they don't like to knowingly raise their dividends higher than they think they can actually sustain it. So, if a company says great things but only barely bumps up its dividend, it's a signal that not all may be as good as it seems.
No. 3: Watch its balance sheet
Dividends may not be guaranteed payments, but bond interest and principal payments take a much higher priority for a company. If a company misses a bond payment, it faces default. The penalties for defaulting can be as severe as loss of control of the company by its shareholders or even forced liquidation. As a result, if a company can make its bond payments, it generally will make its bond payments, even if that means completely eliminating its dividend.
As a result, if you're looking to dividends as a source of income from your portfolio, you'll want to be invested in companies with decently solid balance sheets. Three key measures to look at include the interest coverage ratio, the current ratio, and the debt-to-equity ratio. They each look at different aspects of a company's ability to keep its commitments to its bondholders. The stronger those ratios are, the better the chances are that the company will be able to support its dividend as well.
When you look beyond just yield, dividend stocks can shine
Image source: Getty Images.
Over the long haul, well-chosen dividend stocks can not only provide good income levels today but also the potential for superb overall total returns as well. Whether you're looking for higher investment income than you can get in even long-term government bonds or for that overall total return potential, dividend-paying stocks may just be what you're after.
Still, to be successful, you need to look beyond just what you see offered as a company's dividend yield and to the quality of the business behind that dividend. If you look for companies that offer decent payouts, have reasonable track records of growing their dividends in a sustainable way, and have solid balance sheets, it improves your chances of picking winners. And that could easily be worth thousands of dollars to your overall portfolio.
Chuck Saletta has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.
