How to Pick Winning Dividend Stocks
Do you need more income? Join the crowd.
It seems everyone is scouring the landscape these days for decent income investments to beef up their monthly take-home – especially now with the price of gas and other everyday items skyrocketing.
In fact, if dividend-paying stocks aren’t a major part of your portfolio, the odds of being successful in the markets are stacked against you.
An exhaustive study of stock market returns from 1871 through 2003 showed that over a 135-year period owning stocks and reinvesting the dividends produced 97% of all stock market returns. Meanwhile a paltry 3% was produced by capital gains.
Dividend stocks are safer too. The very same qualities that allow companies to pay steady dividends means they’re much less vulnerable to broad market drops than your typical stock.
And right now corporate America is willing to pay even more in dividends.
Companies are on pace to pay a record $263 billion in dividends to shareholders over the next year even though the S&P 500 Index is still more than 10% below its peak, according to S&P Capital IQ reports.
“We’re seeing good dividend increases across the board,” Richard Helm of Cohen & Steers Dividend Value fund told USA Today.
Buying Great Dividend Stocks
It’s no secret – a company’s dividends play a major role in their performance. Yet many investors completely ignore this important fact.
But you can’t just plunk your money down on any old dividend stock.
You see, most people get “income investing” all wrong.
They either settle for dividends that are much too low and never grow a penny or they take on way too much risk.
But you can always do better than that if you know what to look for.
Here are three keys to help you identify a great dividend stock…
#1 – Check the Payout Ratio
Some companies may seem to be humming right along, but the truth is they’re consistently paying out more in dividends than they take in. After a few years of this, the cash runs out and they have to cut or eliminate the dividend…or worse.
The payout ratio (P/R) helps you sort the wheat from the chaff.
A low payout ratio means a company has enough cash to pay off debt, with money left over to invest in growing the business.
To calculate the payout ratio simply divide the annual dividend by earnings per share.
If a company pays an annual dividend of $1 per share and earns $2 per share, the payout ratio would be 50%. Conversely, a dividend of $4 a share with the same earnings would have an unsustainable P/R of 200%.
In general, stocks with a payout ratio under 60% provide an adequate margin of safety, but as always your personal risk tolerance should be the determining factor.
#2 – Find Companies with Growing Dividends
If a company is truly a great investment, profits should be going up, cash should be going up and dividends should also be going up.
But truly savvy income investors focus on companies that raise distributions every year.
And the very best companies have consistently raised dividends for long periods of time.
Typically these businesses have wide moats and strong brands. Companies like McDonald’s Corp. (NYSE: MCD) and Wal-Mart Stores Inc. (NYSE: WMT) are able to raise their dividends over time because they can pass cost increases on to consumers and keep profit margins growing.
Look for companies that have been increasing their dividend for at least five years. These companies should do well during inflationary times and the rising dividend will also help investors keep their purchasing power growing as well.
#3 – Calculate the Return on Investment
When you make an investment you should always know what your return is. You can project your return on investment (ROI) by adding the dividend to the increase in a stock’s price and dividing it by your original investment.
Say you buy a stock for $10 a share that pays 40 cents a share in annual dividends. The stock goes up $1 per share the next year, giving you a profit of $1.40. Divide that by your original investment of $10 and you have an ROI of 14%.
Look for dividend stocks that have consistently beaten the returns on the S&P 500 Index. The extra margin of safety built in to dividend stocks also exposes you to less risk.
With income hard to come by, dividend stocks are a wise investment choice for any portfolio.
But as always you need to do your due diligence to tailor them to your own unique needs.
In my next story, I’ll delve into the world of foreign dividend stocks. It is another great way to add income and diversity to your portfolio.
– Don MillerSource: Money Morning
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