Today’s low interest rates—plus the prospect of below-average stock returns over the coming decade—are a one-two punch for both income-focused investors and savers struggling to regain lost ground in the wake of an uneven recovery. However, whether you’re looking to generate extra income or to potentially pump up total returns from your stock portfolio, dividend-paying stocks are uniquely suited to help soften the blow.
Here’s what to know about dividend stocks, and how to pick the best ones for you.
The perks (and pitfalls) of dividend payers
Dividend payers tend to be big, well-established companies that have an abundance of cash. “They often can’t compete with the rapid appreciation of fledgling, fast-growing companies, so they use dividend payouts as an enticement,” says Steve Greiner, vice president of Schwab Equity Ratings®.
Dividends, when reinvested, can significantly boost total returns over time, making dividend-paying stocks an attractive option for older and younger investors alike.
For example, if you invested $1,000 in a hypothetical investment that tracked the S&P 500® Index on January 1, 1990, but didn’t reinvest the dividends, your investment would have been worth $8,982 at the end of 2019. If you had reinvested the dividends, you would have ended up with $16,971—nearly twice as much (see “More bang for your buck,” below).
More bang for your buck
Source: Charles Schwab.
Data from 01/01/1990 through 12/31/2020. Calculations assume a starting portfolio value of $1,000. Indexes are unmanaged, do not incur management fees, costs, and expenses, and cannot be invested in directly. Past performance is no guarantee of future results.
With the S&P 500 yielding 1.52% as of December 31, 2020, dividends could also prove an attractive alternative to Treasuries and other fixed income investments in the coming years. “Of course, dividend-paying stocks are generally much riskier than bonds, something income investors in particular should consider when weighing their options,” Steve says.
What’s more, dividends aren’t guaranteed, unlike, say, the interest payments from Treasuries. Companies can trim or slash their dividends at any time, a risk that was realized in 2020 after 68 of the roughly 380 dividend-paying companies in the S&P 500 suspended or reduced their payouts.
“Fortunately, companies generally only cut dividends when they’re in distress,” Steve says, “so favoring those with sound financial metrics can help mitigate this risk.”
How to pick dividend stocks
These six tips can help you identify dividend-paying stocks with strong financial health:
1. Don’t chase high dividend yields: “There’s a reason—and not always a good one—that a security is offering payouts that are well above its peers or the broader market,” Steve says. “Before jumping at a big yield, try to determine why it’s so high.”
Dividend yield is calculated by dividing a stock’s total annual dividend payouts by its current share price. If a high or rising yield is due to a shrinking share price, that’s a bad sign and could indicate that a dividend cut is on the horizon. If a rising dividend yield is due to rising profits, on the other hand, that’s a much more auspicious sign. “When net profits rise, dividends tend to follow suit, so just be sure you know what’s causing the increase before buying the stock,” he says.
2. Assess the payout ratio: This metric—which is calculated by dividing dividends per share by earnings per share—tells you how much of a company’s earnings are going toward the dividend. “A ratio higher than 100% means the company is paying out more to its shareholders than it’s earning,” Steve says. “In such cases, it may be able to cover its dividends from available cash, but that can last only so long.”
If a company whose stock you own is losing money but still paying a dividend, it may be time to sell. “Dividend payers in financial straits may try to stave off a dividend cut—which can drive away shareholders—by funding payouts with borrowed funds or dwindling cash reserves,” Steve says. “It’s rare that such measures turn things around, though. They’re usually just delaying the inevitable.”
3. Check the balance sheet: High levels of debt represent a competing use of cash. “If push comes to shove,” Steve says, “the company is going to pay its creditors before it pays its dividends.”
A good rule of thumb is to favor companies with a “current ratio”—a measure of the company’s current assets versus its current liabilities—of 2 or higher, which is a good indicator of its ability to cover its short-term obligations.
4. Look at dividend growth: Generally speaking, you want to find companies that not only pay steady dividends but also increase them at regular intervals—say, once per year over the past three, five, or even 10 years. Indeed, companies that grow their dividends tend to outperform their peers over time (see “Supersize me,” below).
Source: Compustat, Ned Davis Research, S&P Capital IQ, and S&P Dow Jones Indices.
©2021 Ned Davis Research, Inc. Further distribution prohibited without prior permission. All rights reserved. See additional explanatory notes and disclosures at ndr.com/copyright.html. For data vendor disclaimers, refer to ndr.com/vendorinfo. Past performance is no guarantee of future results.
Not only that, but “a strong history of regular dividend growth also helps keep pace with inflation—which is particularly valuable to income-seeking investors,” Steve says.
Nevertheless, you probably should give companies a break if they didn’t increase dividends in 2020, or if they don’t in 2021. “Most have been hoarding cash to help weather the economic uncertainty, so it’s not unreasonable for them to keep dividends flat until the economy bounces back,” Steve says.
5. Understand sector risk: Some sectors offer a more attractive combination of dividends and growth than others—but they also offer different risk characteristics that you should consider when researching dividend payers for your portfolio. Stocks from the banking, consumer staples, and utilities sectors, for example, are known for steady dividends and lower volatility, but they also tend to offer less growth potential. Dividend-paying tech companies, on the other hand, could offer attractive dividends along with the opportunity for larger price gains, but they also tend to be much more volatile.
“If you’re a long-term investor, you might be willing to accept tech’s higher volatility in exchange for its growth and income prospects,” Steve says. “But if you’re nearing or in retirement, you might want to stick with dividend payers from less-volatile industries.”
6. Consider a fund: If you’re worried about the potential for price declines eroding the value of your dividend stocks, consider instead a dividend-focused exchange-traded fund (ETF) or mutual fund. Such funds typically hold stocks that have a history of distributing dividends to their shareholders, and they can provide a greater level of diversification than you can achieve by buying a handful of dividend-paying stocks.
Do your homework
No matter what stage of life you’re in, dividend-paying stocks can be a great way to supplement your income and improve your portfolio’s growth potential. Just be sure you research the companies’ overall financial health, not just their dividend rates, before investing.
When not to reinvest
Three situations in which you might want to deploy dividend payouts elsewhere.
- You’re in or near retirement: When you’re living off your savings, taking income from your dividends allows you to let more of your portfolio stay invested for growth. If you’re nearing retirement, on the other hand, you can use the payouts to build up your cash and short-term reserves as you prepare for the transition to life after work.
- Your portfolio is out of balance: Reinvesting the dividends of a well-performing investment back into that investment can throw your portfolio off balance over time. In such cases, you might want to take the cash and reinvest it elsewhere.
- The investment is underperforming: If you’re worried about an investment’s future prospects but aren’t quite ready to let it go, you may not want to reinvest the payouts back into that investment. Instead, you might use the dividends to dip your toe into prospective investments that could ultimately replace the underperforming investment.