Delight in Dividend-Paying Stocks

What are Stock Dividends?

Now, on to stock dividends. Stock dividends are a way that some companies share profit with their shareholders. Companies usually send out a quarterly cash dividend payment to each investor based on the number of shares owned. As you might guess, the companies that can pull this off are usually not young or still struggling for dominance in their marketplace. They don’t need to retain and reinvest every penny of profit back into the business, like a fledgling company usually does. No, dividend-paying companies tend to be much more established and stable, such as DuPont or Procter & Gamble. Contrast these stalwarts to successful, but less mature non-dividend-paying stocks, such as Netflix or Amazon.

Dividend-payers have already achieved a measure of success, but don’t attract new investors with lofty visions of double-digit growth. Their allure to investors is the security of some immediate fixed income as well as a stock price that should be less volatile than non-dividend paying alternatives. During bear markets, these more stable investments can help investors offset losses.

What’s the Pay-Out?

It’s not uncommon to see dividend yields in the neighborhood of 3-6%. Right now Coca-Cola’s dividend yield is 3.65% and 3M’s is 3.97%. A dividend yield is simply a year’s worth of dividends expressed as a percentage of the current stock price. The formula is: [Annual Dividends per Share / Price per Shar. To give you an example with really simple math, consider a company that expects to pay $1 dollar a quarter, or $4 a year, per share in dividends. If the stock is trading at $100 per share, then $4 divided by $100 equals a dividend yield of 4%. The yield tells you how much income you get for each dollar you invest—or in layman’s terms, the bang for your buck.

Don’t Pay Me So Much

But here’s a tip: if a dividend is too high, it may be suspicious. For example, the failed investment bank Lehman Brothers had a 13% dividend in early 2008. In hindsight, this was a pay-out to its shareholders that the company certainly couldn’t afford. A stellar dividend yield can also be the result of plummeting share prices. Remember the formula for dividend yield: [Annual Dividends per Share / Price per Shar? If the price per share drops, but the company doesn’t reduce the dividend per share, the yield percentage actually increases even though the company may be in trouble!

A really high dividend yield should make investors consider whether it’s sustainable, especially in a difficult economy. Sometimes companies will do everything possible not to cut dividends, even when they can’t afford them. That is because they fear that reducing dividends may be a signal of weakness to investors and competitors. Some companies would rather lay off employees, sell assets, or even borrow money to find the cash to continue to pay dividends. That could be a bad decision that will ultimately hurt the company and cause the share price to decline over the long-term. And eventually a struggling company will be forced to cut its dividend payment anyway.

Choosing Dividend Stocks

So even though dividend stocks sound like they dish out free money to investors, choosing the right ones is important. They need to be well-managed with a sensible plan regarding dividend payments. Stocks with a solid dividend history, like Kellogg or Johnson & Johnson which are paying 3.47% and 3.58% right now, may be able to maintain or even raise their payouts to keep pace with inflation.

You can research good dividend stocks for free at sites that have a stock screener such as MSN Money or Google Finance. There are also many services and publications that will spoon-feed them to you for a monthly subscription fee. Consider Morningstar.com, InvestorsDailyEdge.com, and Dividend.com for well-researched and timely dividend advice.

Buying Dividend Stocks

Another way to take advantage of dividend stocks is to reinvest the dividends by buying more stock shares. That allows you to systematically increase your holdings without having to invest money out of pocket. But remember that there is no guarantee that a dividend-paying stock will be able to maintain its payout indefinitely. In order to grow earnings, a company may have to reduce or eliminate dividends during challenging times.

And one final tip about dividend stocks: since dividends are taxable income, a great way to buy dividend stocks is within a tax-advantaged account such as an IRA. A traditional IRA doesn’t eliminate taxes, but it does defer them until you retire or make other qualified withdrawals from the account. 

As with all things in life, moderation is usually the key to success. If you gravitate toward risky investments with huge upside potential, consider buying some less-risky dividend stocks for balance. Even if income investing sounds too old-fashioned or conservative for you, adding them to your portfolio can help to smooth out market volatility.

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Chi-Ching, that’s all for now, courtesy of Money Girl, your guide to a richer life.