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If you are interested in investing in the stock market, you probably know that there are several different categories of stocks. There are growth stocks, and value stocks; there are also various industries, like tech companies or consumer good companies.
You may have heard of “dividend” stocks, or companies that pay out a dividend to their investors. In the past, these were considered conservative companies, and they usually attracted investors who were not as interested in substantial growth of their investment as they were in preserving the capital and in generating a steady income stream.
Research done recently has shown the true power of dividend stocks. In a 2012 study, a research team demonstrated that during the period of 1973 to 2011, companies that paid and raised their dividends on a consistent basis outperformed all stocks that paid dividends and the ones that did not pay dividends.
In other words, dividends contribute to a significant portion of a stock portfolio’s returns, in both bull and bear markets, and not including these companies in your own portfolio is a big mistake.
But not every dividend company is the same. The current thinking is that specific ones known as dividend-growth companies are the ones that offer the best potential – the companies pay a good and growing dividend, and they also offer the opportunity for share price growth as well as steady, reliable income payments.
To find dividend-growth stocks, you need to evaluate several criteria, in order to select the best companies for your portfolio.
First of all, you want to consider the company’s dividend metrics. This begins with the current yield (total distribution for the year divided by the current price). This number is generally in the range of 0 to 4%. The current dividend yield of the entire S&P 500 index is approximately 2%, so it doesn’t make sense to choose individual companies that yield less, if you are looking to generate income. (Otherwise, you can just buy the S&P 500 ETF and expect to match the market’s performance.)
The second set of numbers you should evaluate is the company’s history of paying and raising its dividend. This is important. It’s not enough to simply pay a dividend every quarter – you want that dividend to be getting bigger every year, as well. You can find a company’s dividend metrics in several places; one of the most useful and free compilations is at www.dripinvesting.org. There you can find a detailed worksheet with many statistics, and it’s updated monthly.
You want to check the company’s number of years of consistently raising its dividend, as well as the company’s 5 or 10-year Dividend Growth Rate. This DGR tells you how the dividend has been growing over the past, and gives a pretty good indication of how it will grow in the future.
Companies that have a long history of raising their dividend and that make it onto one of several Dividend Champion lists are less likely to cut or freeze their dividend than companies that do not have a consistent history.
The third dividend metric that is important is the payout ratio, which is the amount of the distribution divided by the earnings per share, represented as a percentage. If a company is paying out all of its earnings as a dividend, there are two possible problems: 1) there is no money available for re-investing in the company for further growth and 2) if there is a drop in earnings, the company may have to cut the dividend.
Another number to evaluate is the stock’s performance over the past twelve months. Is it increasing on par with the S&P 500? Or has it dropped significantly? A company’s dividend yield goes up as its price goes down, but that doesn’t necessarily mean it’s a good buy!
Also, consider the company’s projected 5-year growth rate. If a company is not predicted to grow over the next five years, how can it continue to pay and raise its dividend?
And, finally, you want to make sure you are not overpaying for your income. Looking at the current PE of a company, as well as its historical range, can tell you if your stock has been bid up to a price that is possibly higher than you are willing to pay. For example, if a company generally trades in a PE range of 15-17, and its recent popularity has pushed it up to a PE of 20, you may want to wait for a price pullback before you enter your position.
While past performance does not guarantee future success, in the case of long-term dividend champions, it does tend to be an excellent predictor. When you take all of these factors into consideration, and choose the companies that perform well on all of the metrics, you will be well on your way to filling your portfolio with companies that stand the best chance of rewarding you in the future.