What You Need to Know About Dividends

It is all too easy for investors to overlook dividend yield when picking stocks, especially since many of the most high-profile shares of the past few years (Netflix, Apple, Google) have all come from the tech sector, which tends to reinvest profits back into the business, rather than make pay-outs to shareholders. However, dividends represent the most consistent form of income and, depending on the market, a consistent and reliable source for returns. Here’s some important points to consider when hunting for dividend-paying shares.

Should you reinvest?

For those investors who do buy dividend-paying stocks, you face a choice: should you take the cash, or reinvest the money? Here’s the short answer: When you decide to take dividends in additional partial shares rather than in cash, it converts the stated yield into an annual compound yield, which is a far better choice.

Calculating your yield

The second point to remember is that the yield you earn has to be based on the price you pay for buying shares. For example, if a company pays $1.50 per share, if you buy shares at $35, your yield will be 4.3 percent ( 1.50/35 ). However, if the price of stock later rises to $40, the yield would be 3.8 percent ( 1.50/40 ). Even so, if you bought shares at $35, that is the value you should use to determine the yield you actually earn.

How high is too high?

This brings up the most important question of all: Which companies should you pick based on dividend yield? It is not reliable to just pick the company yielding the biggest dividend. An outsized yield could be the result of something very negative that has driven down the share price. For example, if that stock paying a $1.50 dividend were to be considering bankruptcy, the share price might tumble to $20 per share. In that case, the dividend yield would shoot up to 7.5 percent (1.5/20), just as fast as the stock price fell. This looks impressive, but you need to understand the reasons for the large yield, especially since companies can cut dividends when times get tough.

Look for steady growth

The most reliable method for picking high-quality stocks is to look for those companies that have increased their dividend every year without fail, for at least 10 years. This length of improvement tells you a company’s cash flow is controlled carefully and that the company’s management has been able to produce net profits consistently. Such stocks are called dividend achievers ™, a term developed by Moody’s Investor Services in 1979. Moody’s was later acquired by Mergent, Inc. and the index continues to be tracked to this day. Mergent also created an index starting in 2003 representing a composite of companies meeting this definition. It is called the Broad Dividend Achievers Index.

The 2011 list included 191 companies paying higher dividends every year for at least 10 years. Whether you pick stocks based on the published list or use a composite index to invest in these exceptionally well-managed companies, the point to remember is this: Companies that pay consistently higher dividends each year tend to be more profitable and less volatile than average. This may be more important than the actual annual dividend yield. Buying security and safety ensures that the long-term dividend record will continue into the future.

Michael C. Thomsett is author of over 60 books, including Annual Reports 101 (Amacom Books Press), Trading with Candlesticks (FT Press) and the recently released new book, Getting Started in Stock Investing and Trading (John Wiley and Sons).  He lives in Nashville, Tennessee and writes full-time.