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One excellent investing tactic is dividend investing. Historically, dividend equities have fared better with less volatility than the S&P 500. This is due to the fact that dividend stocks offer both capital growth on the stock price and consistent income from dividend payments. Over time, this total return may accumulate.

Dividend stocks are generally preferred by investors seeking lower-risk investments because to their reduced volatility, particularly those who are approaching or have reached retirement. But if you don’t know what to look out for, dividend stocks might still be dangerous. A more detailed look into dividend stock investing for income is provided is this article.

Let’s look at an example. Say you buy 100 shares of a company for $10 each, and each share pays a dividend of $0.50 annually. If you invested $1,000, you would receive $50 in dividend payments over the course of a year. That works out to a 5% dividend yield — not too shabby.

What you choose to do with your dividends is up to you. You can:

  • DRIP — Automatically reinvest them to buy more shares of the company through a dividend reinvestment plan (DRIP).
  • Buy stock in a different company.
  • Save the cash.
  • Spend the money.

Regardless of whether the company’s stock price goes up or down, you would receive those dividend payments as long as the company continues to disburse them.

The beauty of stocks that pay dividends is that part of your return includes predictable quarterly payments. Not every company offering dividend stocks can maintain a dividend payout in every economic environment, but a diversified portfolio of dividend stocks can produce reliable income rain or shine.

Combine those dividends with capital appreciation as the companies you own grow in value, and the total returns can rival and even exceed those of the broader market.

Here are some well-known companies that have a long history of paying dividends, along with their dividend yields at recent stock prices and the per-share amount of each dividend:

CompanyIndustryDividend YieldQuarterly Dividend Amount
Chevron (NYSE:CVX)Energy3.99%$1.51
Procter & Gamble (NYSE:PG)Consumer defensive2.53%$0.94
Lowe’s (NYSE:LOW)Consumer cyclical2.05%$1.10

Procter & Gamble and Lowe’s are among the select group of businesses known as the Dividend Kings since they have both raised their stock dividends for more than 50 years running. They are also included in the group of S&P 500 Index businesses known as Dividend Achievers, which has had dividend increases for more than 25 years running. With a record of dividend increases spanning more than 35 years, Chevron is likewise an Aristocrat. Almost any industry produces dividend stocks, and each company’s dividend and yield % might differ significantly from the next.

Dividend Yield and Other Key Metrics

Before you buy any dividend stocks, it’s important to know how to evaluate them. These metrics can help you understand how much in dividends to expect, how reliable a dividend might be, and — most importantly — how to identify red flags:

  • Dividend yield: This is the annualized dividend represented as a percentage of the stock price. For instance, if a company pays $1 in annualized dividends and the stock costs $20 per share, then the dividend yield would be 5%. Yield is useful as a valuation metric when you compare a stock’s current yield to its historical levels. A higher-dividend yield is better, all other things being equal, but a company’s ability to maintain the dividend payout — and, ideally, increase it — matters even more. An abnormally high dividend yield could be a red flag.
  • Dividend payout ratio: This is the dividend as a percentage of a company’s earnings. If a company earns $1 per share in net income and pays a $0.50-per-share dividend, then the payout ratio is 50%. In general terms, the lower the payout ratio, the more sustainable a dividend.
  • Cash dividend payout ratio: This is the dividend as a percentage of a company’s operating cash flows minus capital expenditures, or free cash flow. This metric is relevant because GAAP net income is not a cash measure, and various non-cash expenses can cause a company’s earnings and its free cash flow to vary significantly from one period to the next. This variability can render a company’s payout ratio misleading at times. Investors can use the cash dividend payout ratio, along with the simple payout ratio, to better understand a dividend’s sustainability.
  • Total return: This is the increase in stock price (known as capital gains) plus dividends paid. For example, if you pay $10 for a stock that increases in value by $1 and pays a $0.50 dividend, then that $1.50 you’ve gained is equivalent to a 15% total return.
  • Earnings per share (EPS): The EPS metric normalizes a company’s earnings to the per-share value. The best dividend stocks are companies that have shown the ability to regularly increase earnings per share over time and thus raise their dividend. A history of earnings growth is often evidence of durable competitive advantages.
  • P/E ratio: The price-to-earnings ratio is calculated by dividing a company’s share price by its earnings per share. The P/E ratio is a metric that can be used along with dividend yield to determine if a dividend stock is fairly valued.

Purchasing equities with the highest dividend yields is a common mistake made by novice income investors. Though they aren’t always bad, stocks with high yields may sometimes have a dropping stock price as a result of the possibility of a dividend cut. We refer to such as a dividend yield trap.

The following actions can help you stay away from yield traps:

  • Avoid buying stocks based solely on dividend yield. If a company has a significantly higher yield than its peers, that’s often a sign of trouble, not opportunity.
  • Use the payout ratios to gauge a dividend’s sustainability. 
  • Use a company’s dividend history — of both payout growth and yield — as a guide.
  • Study the balance sheet, including debt, cash, and other assets and liabilities.
  • Consider the company and industry itself. Is the company’s business at risk from competitors, weak demand, or some other disruption?

Sadly, a yield that looks too good to be true often is. It’s better to buy a dividend stock with a lower yield that’s rock-solid than to chase a high yield that may prove illusory. Moreover, focusing on dividend growth — a company’s history and ability to raise its stock dividend — often proves more profitable.

How to Find the Best Dividend Stocks

Receiving dividends every quarter, month or year is an excellent passive income source. Therefore, finding companies that pay out regularly and have a history of success is crucial. Use the following tips to find the best dividend stocks.

Invest in Companies with Reliable Track Records

Just because a company is worth billions doesn’t mean it’s an ideal investment. The company also needs to pay dividends to its shareholders. As a result, it’s a good idea to check the U.S. Securities and Exchange Commission (SEC) disclosures for records of dividends paid in the past. Generally, a company that has paid its shareholders for the past several years will continue doing so. On the other hand, a company with high earnings but no history of dividend distribution may be an unreliable investment for increasing your passive income.

Additionally, balance is a factor to prioritize. While a company that pays every last penny of its profits as dividends sounds fantastic, it’s not a sustainable practice for a company to have a payout ratio of 100%. In reality, a company that makes steady dividend payments of no more than 60% of its earnings is a strong investment. This way, the company will use some of its earnings to maintain and grow the business, providing even higher returns in the years to come.

Profitability and Robust Cash Flow

Companies that generate substantial income are more likely to pay dividends. On the other hand, a company that reports year-over-year losses will probably suffer stock price decreases and shrink its business operations.

Therefore, cash flow is vital. A profitable company is likely to have better cash flow, which leads to a higher probability of dividends. Looking through a company’s financial reports can help determine whether sizable amounts of money regularly go in and out of its accounts. You’re not necessarily looking for the business with the flashiest product or an initial public offering (IPO) that makes headlines, you’re looking for businesses sitting on piles of cold, hard cash.

Read Also: Creating Multiple Income Streams through Real Estate Investing

Earnings are a critical part of the picture; it’s tough to have cash flow when a business isn’t making more than it’s spending. As a result, checking income projections can help you gauge how likely a company is to pay dividends in the future. Generally, companies forecasting growth of at least 5% over the next several years can provide dividends to their shareholders down the line.

Avoid Debt

Just as cash flow signifies a company’s ability to pay dividends, debt can be a sign that money won’t be flowing an investor’s way. While not all debt is crippling, a company with a debt-to-equity ratio of 2.00 or higher might not be the best investment. Profitable companies with massive debts will likely divert excess cash toward their loans and lines of credit. While taking care of financial responsibilities makes sense for a long-term business plan, it’s not profitable for shareholders. As a result, steer clear of too much debt and focus on companies that are free to use their cash as they wish.

Assess the Industry

Part of doing your homework on a company is considering the wider economic context. Market dynamics and patterns in a specific sector are as significant as a company’s cash flow. For example, a company that has a few strong quarters in a dying industry might not be around in a few years to continue paying dividends.

Conversely, biotech has been a profitable investment for years and will likely continue with the boom of vaccine and antiviral products that resulted from COVID-19. Because medical necessity and international government dollars drive it forward, biotech companies will have plenty of room to grow their business without cash flow issues.

After researching companies that will provide dividends, you can construct a dividend portfolio. Ideally, your assortment of stock holdings will generate passive income once you make your purchases and hold the assets for a little while. However, no investment is a guarantee. Take the following steps to maximize your passive income and cover your risks.

1. Use Dividend Payments as Investments

Reinvesting dividends is an excellent way to increase your passive income. Instead of pocketing dividends, you can use them to purchase additional stock. By increasing your exposure to the companies you’ve chosen, you have higher income potential than before. Reinvesting for multiple years can double your passive income generation. That said, investing always comes with risk, so you also have a chance of losing your extra investments.

2. Time Is on Your Side

Even if your investments seem weak initially, the stock price should increase over time. If you’ve done your research correctly and invested in companies with solid foundations, they will find success, resulting in stock growth.

Additionally, because your stock purchase price is a fixed cost in the past, you benefit the more time passes. In other words, the longer you hold a stock, the more opportunities you have of receiving dividends. For you to make passive income, a profitable company’s stock price doesn’t need to skyrocket. It only needs to keep passing along profits to its shareholders.

3. Be Mindful of Risk

While dividends are excellent as a passive income stream, they can fail. Like any other investment in stocks, bonds, real estate and other assets, there’s a chance your dividend holdings will go south. Specifically, one or more of the companies you invest in may experience years of stagnation or go out of business.

The risks involved are why diversification is essential. In this context, it’s wise to diversify on two levels: firstly, in your investment portfolio, and secondly, in your passive income streams. You can never eliminate risk entirely, but you can reduce it. Don’t put all your eggs in one basket; instead, thoroughly researched investments among a variety of assets and opportunities will provide more reliable returns.

How Much to Invest In Dividends

Your investment in dividends will depend on the stock price, projected returns and your overall financial strategy. For example, let’s say you have $50,000 to invest and have found a company with a stock price of $1,000 per share and a 5% projected annual yield.

Buying five stocks creates $250 of annual passive income, and your goal is to establish $2,500 of passive income per year. As a result, you realize that you could spend your entire investment fund on this company’s stock and reach your goal: $50,000 of stock would create $2,500 in profit annually.

However, investing solely in this company will give you no chance of diversifying your portfolio, and if this one company goes under, you will lose your entire investment fund. Since diversifying helps weather market volatility, it’s probably wiser to put a portion of your money into this company and look for others as well.

An annual passive income of hundreds or thousands of dollars can be generated by dividends. If investors are diligent and risk-averse, a portfolio consisting of equities from multiple profitable companies across various industries can withstand economic downturns and yield a steady income stream for all time. To get the most out of these assets and reach your long-term financial objectives, it’s critical to understand how they may complement your overall financial plan and asset allocation.

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