Why Dividends are Important

I often get asked if investing exclusively in dividend-paying companies will bring the best results. There is no simple answer, but history shows that dividend income is an important part of your total return when investing in common stocks. Increasing stock prices help to build your wealth and beat inflation, but dividends provide a steady return on your investment through thick and thin.

I also receive questions from investors asking me to compile a list of stocks to begin building their initial value investing  portfolios. Whether you are a new investor or an old pro, or whether you are young or old, I usually advise that you include some ultra-conservative companies in your portfolio. I call them core holdings. Owning conservative companies will not only allow you to sleep at night, but will also provide you with modest appreciation and dividend income for many years into the future. When asked how long an investor should hold a stock, Warren Buffett’s answer is: “Our favorite holding period is forever.”

Dividend paying stocks offer two ways to make money with your stocks: The price of the stock can appreciate and the dividend can provide income. Invest in companies with histories of well-founded growth that will continue during the next several years and even decades. A company’s history of steady sales and earnings growth will usually lead to relatively steady appreciation and frequent dividend increases.

Dividends are the regular cash payments that a company sends to you or to your brokerage account. You can, however, instruct the company or your broker to reinvest your dividends into additional shares or fractional shares. Reinvesting your dividends makes sense, because the effects of compounding your dividends will make your investment grow faster.

Many investors focus exclusively on speculative gains (the appreciation), going so far as ignoring dividend payments when reporting stock market results over long periods of time. You might be pleasantly surprised, though, if you include your dividends when you calculate your total return. You will also see that dividend-paying stocks tend to decline noticeably less than stocks with no dividends.

Dividends are hard-earned cash, and a company’s ability to continually pay them provides concrete evidence that the company is performing well. Accounting malfeasance is harder, or impossible, if a large transfer of cash is going to shareholders on a regular basis. Don’t include companies paying really low dividends, because I am referring to companies paying dividends yielding more than 1% per year (calculated by dividing the annual dividend by the current stock price).

There is another common pitfall to be aware of when evaluating dividends and yields. The dividend payout is the ratio of dividends per share compared to earnings per share (DPS divided by EPS). The payout ratio indicates if earnings can support the dividend. A growth company that pays a small dividend will tend to have a lower dividend payout ratio than a well-established “blue chip” company that has a higher dividend payout.

As a rule of thumb, most successful dividend investors avoid companies with a dividend payout ratio above 50% or 60%. Anything above that mark means the company may not be investing enough capital back into the organization. Even though a company’s growth has slowed, it is still critical to reinvest a portion of earnings back into the organization.

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More about Dividend Investing

Dividend investing is a hybrid strategy focused on generating income from your investments while also growing your wealth.


Stock Picks

Tesla Motors

If Tesla ever begins to cut back on development and innovation costs, earnings will soar.

Alibaba

China seems to be raising up its very own version of Amazon in Alibaba (BABA.

Facebook

Roy Ward uses the PEG ratio to determine if the stock is undervalued or overvalued.

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