Sometime last year, as the stock market struggled and interest rates hovered just above zero, small investors discovered dividend-paying stocks. Many who got in early have pocketed gains that significantly outperformed the market as a whole.
A dividend is a premium a company pays to its shareholders, usually on a quarterly basis. It's a way to return profits to shareholders, but not all companies do it. Usually, it's well-established firms with steady, consistent growth and income.
For example, in the telecom sector, both Verizon and AT&T pay what are generally regarded as attractive dividends. AT&T, for example, currently pays $1.76 per share per year. Verizon pays $2.00 per share.
A dividend payment is called a stock's “yield,” and is a percentage of the money required to purchase the stock. Today, AT&T is trading at $29.83 per share. By dividing the dividend -- $1.76 – by the share price, $29.83, you arrive at the annual yield – 5.9%. That means if you purchased AT&T stock, the investment would earn at a rate of 5.9 percent, far more than any CD.
At the same time, the price of AT&T stock could rise after you purchase it, increasing the value of your investment. If the stock gained 2% in value in a year, it would make for a combined return of 7.9 percent.
So, why doesn't everyone rush out and buy AT&T stock, or Verizon, Coca-Cola, IBM, and all the other stocks that pay dividends? Because, as with most investments, there is an element of risk. Like any stock, the value could go down, not up.
Also, there is no guarantee that a company will not cut its dividend if it encounters hard times, or even eliminate it all together. That happened in 2010 after the Gulf oil spill. At the time, British Petroleum (BP) was a high-flying stock paying an astounding 8% yield.
After it became clear that BP faced huge liabilities from the spill, and would likely not be able to keeping paying its shareholders, the stock price plummeted. Indeed, weeks later BP was forced to eliminate its dividend. Investors who were not quick to sell not only lost the dividend, but saw the value of their original investment in BP stock decline.
That's why investors who pursue a strategy of dividend stocks must choose their investments wisely and and follow their stocks closely, sensitive to any change in direction. How do you pick a good dividend stock?
First and foremost, the company behind the stock should be strong and stable. The question you must ask, can this company continue to keep making these payments to shareholders?
One way to answer this is to research the company and the sector in which it operates. Is it a stable, well-run firm in a business that has potential for growth?
The second clue is to look at the company's earnings per share, and compare that to the dividend it is paying.
The 50% rule
If the company is earning $1 per share but is paying a dividend of $2, chances are it will not be able to do that for long. Stock guru Jim Cramer has suggested a good rule of thumb is to select stocks for which the dividend is not more than 50% of the earnings per share.
That brings us to a third factor: don't be greedy. In your research you will find plenty of stocks paying 8% or more in yield. But many will be companies you have never heard of, in sectors you know little about.
Often times the yield is high because the price of the stock has recently dropped in dramatic fashion. Here's an example: suppose company A's stock is trading at $40 per share and is paying a dividend of $2 per share. That's a yield of 5%.
But then something bad happens, and the stock price plunges to $10 per share. For now, the company is still paying the $2 dividend, but now the yield – based on the new $10 stock price – has surged to 20%! But does anyone think that kind of payout is sustainable?
That's why careful research is required. Especially now, since many attractive dividend stocks have dramatically risen in price over the last few months because investors have purchased them for their stable yield. However, as the stock value rises, the yield goes down, unless the company moves to increase their dividend.
Still, for a long-term investor dividend stocks, chosen carefully, can provide a 3% or more income stream, if you choose wisely. Again, any equity investment carries risk, so you should do your research and consult with a knowledgeable financial professional before making any investment decisions.