Dividends can play an important role in any investor’s portfolio. They shouldn’t represent all of your investments, but investing in dividend-paying stocks can create a great source of income in the future. For older companies whose stock price may not have room for excessive growth, dividends provide a way to motivate and reward investors. And when you look at the total returns of many investors, a large portion of that comes from profits.
As you invest in dividend stocks, be sure to dig deeper into the companies to make sure you’re making the right choice and not be fooled by what appears to be. When it comes to profits, all that glitters isn’t gold.
Look beyond the dividend yield
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Often the most advertised metric for dividend stocks is the dividend yield. A company’s dividend yield is the annual dividend in relation to its share price. If a company pays $2 in dividends annually and its share price is $100, then the dividend yield is 2%.
But this is the reason why dividends are misleading per se. If that same company’s stock price drops to $50, its new return will be 4%. Without digging deeper, this increase in return may seem profitable, but it does not give a backstory as to why the return doubled – that is, the stock price fell by half.
In this case, the stock price may have fallen significantly due to factors unrelated to the core business, or it may have fallen due to a change in something fundamental in the business and its operations. Whatever the case, you always want to be in the know, so you’re not blindly investing.
Do not overlook the percentage of payment
Having a solid stock that pays dividends is one thing, but you want to make sure the return is sustainable over the long term. This is where a company’s payout ratio can come in handy. The payout ratio tells you how much of a company’s dividend you’re paying in dividends. You can calculate the dividend ratio by dividing a company’s annual earnings by its earnings per share (EPS), both of which can be found in the broker’s platform or the company’s financial statements.
A payout ratio of more than 100% means that the company is paying more dividends than it brings in. Spoiler alert: This is not a good thing. If the company continues to pay more than it brings in, this is not sustainable in the long run. At some point, the dividend will either need to be cut, or the company will run out of money. Neither of them is good for investors who focus on dividends.
There is no specific number to look for when examining a company’s earnings ratio because some industries prefer dividend payouts more than others. But in general, you want to look for ratios between 30% and 50%, more or less.
Dividends can be a supplement in retirement
One of the great things about dividends is that they can provide additional income when you retire. If you are intended to invest your dividends and take advantage of the Broker Dividend Reinvestment Program (DRIP) – which automatically reinvest dividends to buy more shares of the company or fund that paid them – you can easily find yourself in a situation where you receive thousands of monthly retirement income. All it takes is time and consistency.
But along the way, remember not to be deceived by the dividend yield; Look deeper at Why. You will likely find (and hopefully avoid) red flags along the way.
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