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Dividend Stocks: Are They the Right Choice for You?

·11 min read
z_wei / Getty Images/iStockphoto
z_wei / Getty Images/iStockphoto

A dividend is a payout that a company makes to shareholders. Dividends usually are paid in cash once per quarter, or four times per year, but not all stocks pay them. Younger, faster-growing companies tend not to pay dividends because they need to use their cash flow for further expansion. Larger, more established companies with regular and predictable cash flows generally do pay out dividends.

You can predict with some confidence if or when a company will pay a dividend based on where it is in its business life cycle. Startups and newer companies often face a cash crunch, and their money is most efficiently spent by reinvesting capital into business expansion, product development and customer acquisition. Once a company has matured into a consistent revenue earner, it has already built its customer base and perfected its products. Burning through cash like a young company would be an inefficient use of capital at this stage, so this is when dividends become a better way to spend profits.

Dividend stocks can thus generate shareholder returns in two ways: from stock price appreciation and through income, in the form of the dividend. Investors might be interested in dividend stocks simply for the income while viewing the capital appreciation component as a potential kicker. Or they might be looking for a hybrid type of investment that combines both income and growth. Others might view dividend stocks as defensive, as they tend to hold their value better in a general market sell-off. Still others might see dividend stocks as a way to earn money even if the market doesn’t go up.

Whatever reason attracts you to dividend stocks, it’s important to understand how they work and how you should evaluate them before you invest. Here’s an explanation of the ins and outs of dividend stocks and a look at some current top performers.

Here’s what this guide to dividend stocks will cover:

  • What Is Dividend Yield?

    • How To Calculate Dividend Yield

  • Current Highest-Yielding Dividend Stocks

  • How To Evaluate Dividend-Paying Stocks

  • Common Mistakes When Investing in Dividend Stocks

    • Buying Only the Highest Yielding Stocks

    • Not Reinvesting Dividends

    • Not Using a Portfolio Approach

  • Alternatives to Dividend Stocks

    • Dividend ETFs

    • Bonds

    • Real Estate

    • Preferred Stocks

What Is Dividend Yield?

Dividend yield is a quick and easy way to compare the dividend payouts of two different companies. The net cash paid out per share isn’t a good comparison because companies with higher stock prices will pay much higher monthly cash payouts on an absolute basis, but you’ll be earning less in terms of a return on your investment. The formula for calculating dividend yield should help make this clearer.

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How To Calculate Dividend Yield

It’s straightforward to calculate a dividend yield. Simply take the total dividend payouts a stock makes over the course of an entire year and divide that amount by the current stock price.

Say, for example, that stock XYZ pays out a $0.50 dividend quarterly, for a total of $2 per share over the course of an entire year. If stock XYZ trades at $50 per share, its yield is 4% ($2 per share / $50 per share = 0.04).

Now, compare this payout with stock ABC, which has an annual dividend of $3 but trades at $300 per share. Although the annual dividend of stock ABC is higher than that of stock XYZ — $3 per year vs. $2 per year — stock ABC only has a yield of 1%. For the same amount of money invested, stock XYZ will pay investors four times as much.

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Current Highest-Yielding Dividend Stocks

The current highest-yielding dividend stocks in the Standard & Poor’s 500 index are subject to change on a day-to-day basis, mainly because fluctuations in stock prices affect dividend yields. Occasionally, a dividend cut will knock a stock out of the rankings, or at least knock it lower. AT&T is a prime example. The company announced on May 17, 2021 that it would be trimming its dividend payout ratio to 40% to 43%, meaning its dividend will likely drop by about 40%. So, do your research before piling into a stock just because it has a high current dividend. Here’s a look at the current highest-yielding, dividend-paying stocks in the S&P 500 as of May 18, 2021.

Top-Paying S&P 500 Dividend Stocks

Stock Symbol

Stock Name

Stock Price

Cash Dividend

Stock Dividend Yield

T

AT&T Inc.

29.55

$2.08

7.04%

OKE

ONEOK, Inc.

53.98

$3.74

6.93%

MO

Altria Group, Inc.

49.99

$3.44

6.88%

LUMN

Lumen Technologies, Inc.

14.58

$1.00

6.86%

WMB

The Williams Companies, Inc.

26.33

$1.64

6.23%

IRM

Iron Mountain Incorporated

42.57

$2.47

5.80%

XOM

ExxonMobil Corporation

60.43

$3.48

5.76%

PPL

PPL Corporation

29.33

$1.66

5.66%

CHV

Chevron Corporation

87.60

$4.41

5.03%

PM

Philip Morris International Inc.

97.69

$4.80

4.91%

IBM

International Business Machines Corporation (IBM)

143.91

$6.56

4.56%

ABBV

AbbVie Inc.

117.21

$5.20

4.44%

O

Realty Income Corporation

65.48

$2.82

4.31%

SPG

Simon Property Group, Inc.

122.57

$5.20

4.24%

MAC

Macerich Co.

14.53

$0.60

4.13%

DOW

Dow Inc.

69.53

$2.80

4.03%

ED

Consolidated Edison

77.74

$3.10

3.99%

AMCR

Amcor, plc

12.19

$0.47

3.82%

PBCT

People’s United Financial, Inc.

19.11

$0.73

3.82%

FRT

Federal Realty Investment Trust

112.69

$4.24

3.76%

NAVI

Navient Corporation

17.29

$0.64

3.70%

KHC

The Kraft Heinz Company

43.69

$1.60

3.66%

CAH

Cardinal Health

56.27

$1.96

3.48%

KMB

Kimberly-Clark Corporation

132.38

$4.56

3.44%

WMB

Walgreens Boots Alliance, Inc.

55.26

$1.87

3.38%

Information is accurate as of May 18, 2021

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How To Evaluate Dividend-Paying Stocks

Like all investment strategies, evaluating top dividend-paying stocks is part art and part science. Anyone with a computer can pull up a list of the highest-yielding stocks in the S&P 500, but numbers can be deceiving. To pick sound investments out of that list, you’ll have to do a little homework.

One of the guiding principles of investing is that you should never buy a stock simply because of its yield. Just as with a stock that doesn’t pay any dividend at all, you’ll need to look at other important metrics first, with the foremost of these being a company’s earnings.

Earnings are one of the primary long-term drivers of stock prices, and they’re also the backbone of the cash payout known as a dividend. Without consistent earnings, no company can sustain a dividend, and without growing earnings, no company can raise its dividend. Even worse, a company with declining earnings is likely to see not just a drop in its share price but also a cut to its dividend.

To avoid these problems, investors must look to see if a dividend is sustainable over the long term. Ideally, you’ll also want to find a company that has the potential to consistently raise its dividend. A subgroup of stocks known as “dividend aristocrats” have paid a dividend for at least 25 straight years and have also raised their dividends at least annually over that period. Although past performance is never a guarantee of future results, this is the type of company you should be looking for as a dividend investor.

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Common Mistakes When Investing in Dividend Stocks

It’s easy to make mistakes when it comes to investing in dividend stocks because the premise seems so easy — simply pick the best stocks to buy and go on your way. The problems with this approach are multifold. Here’s a look at some of the most common mistakes investors make when buying dividend stocks.

Buying Only the Highest-Yielding Stocks

Stocks that pay a high dividend yield are exciting because you earn more cash just for holding on to a stock, no matter how it trades. In that sense, the higher the dividend, the better. But like all good things, there’s a limit you don’t want to cross when it comes to high dividends. Some stocks have a high current dividend yield for a reason. Often, it’s because the stock price has cratered, creating an unnaturally high — and unsustainable — dividend.

For example, revisit hypothetical stock XYZ, with its $2 annual dividend and $50 share price. If the company reported huge unexpected losses and the stock got cut in half, its dividend yield would skyrocket up to 8% ($2 annual dividend / $25 share price). That sounds great until you realize that the company’s earnings — which are now losses — can no longer sustain that dividend. In that scenario, the dividend is likely to get cut, which can lead to even further share-price losses. You can check on whether a company is likely to continue its dividend by looking at its payout ratio, which is the ratio of a dividend to a company’s net income. If a payout ratio is over 100%, a company is paying out more than it is earning, making a dividend cut more likely. Do your homework and verify that the dividend is sustainable.

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Not Reinvesting Dividends

Some investors get frustrated that their returns seem to be nowhere near those provided by the major market averages. One of the reasons investors often fall short is that they don’t reinvest their dividends. The annual returns published for the major market indices every year assume the reinvestment of dividends. Although you might think that dividends “only” comprise about 2% of the S&P 500’s return, when these dividends are reinvested and compounded, they contribute a major component of the market’s overall return. Failure to reinvest your dividends can hold back your total net return, especially in the long run.

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Not Using a Portfolio Approach

It’s easy to quickly scan the list of highest-paying dividend stocks and just pick names that you are familiar with or that pay a high dividend, but you could be doing yourself a disservice if you don’t view your stock picks as part of an overall portfolio. Many high-dividend stocks come from the same industries — especially energy, utilities and real estate investment trusts — so if you simply load up on the highest-paying names, you might end up with a highly concentrated portfolio.

One of the main tenets of modern portfolio theory is that you need to diversify your investments to reduce your risk. If all you buy are high-dividend oil stocks, your whole portfolio could crash at the same time, even if the rest of the market is going up. It’s important to look at stocks as actual businesses tied to specific segments of the economy and not just ATMs.

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Alternatives To Dividend Stocks

Dividend stocks have definite advantages, but they also have drawbacks. For starters, they are not immune to general market sell-offs, and they are susceptible to company-specific problems such as reduced earnings. Here are some alternatives to dividend stocks that can still provide you with income and handsome returns.

Dividend ETFs

Dividend exchange-traded funds, or ETFs, are essentially mutual funds that trade on the stock exchange. A dividend ETF is a portfolio of dividend-paying stocks that either passively tracks a stock index or is actively managed by an investment company. When you buy shares of a dividend ETF, you effectively own shares in all the investments within the fund. Dividend ETFs can help diversify your portfolio while still offering both income and growth.

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Bonds

Bonds are like IOUs issued by companies to investors. In exchange for your money, companies agree to pay you interest and return your principal at a designated time, known as the maturity date. Bonds are often safer, more stable investments than stocks. They also tend to pay a higher income than dividend-paying stocks. But they are not growth investments, as you’ll only receive the money you originally invested at maturity.

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Real Estate

Real estate is a great choice for diversification because it doesn’t trade in lockstep with the stock market. Investing in income properties can generate a high revenue stream while also providing potential capital appreciation. You can avoid the hassle of owning real property directly by purchasing a REIT, which trades on the stock market and, like a mutual fund or ETF, relies on professional investors to buy and sell properties on your behalf. All the while, you’ll earn a regular dividend, often paid monthly.

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Preferred Stocks

Preferred stocks don’t have the same capital appreciation as common stocks, but they tend to pay higher dividends. Furthermore, these dividends are prioritized in the corporate structure, meaning they are paid out before dividends on common stocks. For investors seeking the highest possible income, without as much regard for capital appreciation, preferred stocks can be a better option than regular dividend stocks.

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More From GOBankingRates

Amen Oyiboke contributed to the reporting of this article.

Last updated: May 21, 2021

This article originally appeared on GOBankingRates.com: Dividend Stocks: Are They the Right Choice for You?