Stocks are categorized as growth, value, and income or dividend stocks. When investors buy growth stocks, they are betting that their stocks will increase in value and they will be able to sell them for a profit.
Value stocks, on the other hand, are priced below their real value, often due to a temporary change in the company’s reputation.
When investors purchase value stocks, they are hoping that prices will rise again when public perception of the company becomes more positive.
Dividend stocks are those that pay the highest dividends, and they are especially favored by retirees. People who invest in high-dividend stocks are looking for a stable passive income, and they may also be looking for a more reliable investment during a bear market. Investors who are interested in high-dividend stocks need to know what to look for and also what to avoid.
Definition Of High-Dividend Stocks
In general, a stock is considered to pay a high dividend if it’s paying above 3%. This criterion is based on a stock market average that has stayed well below 4% for many years, as well as current low federal interest rates.
Some other common features of high dividend stocks include large mature companies worth at least $2 billion in market capitalization, a payout of less than 70% of profits in dividends, a positive cash flow, and solid earning potential.
Investors who favour high-dividend stocks are generally people who are looking to supplement a fixed income. Retirees in particular benefit from income stocks, which are now seen as a favorable alternative to the traditional “4% Rule.”
In the past, experts advised investing 60% of savings in stocks and 40% in bonds and then selling 4% of the portfolio for each year of retirement.
However, falling bond prices have made this strategy less effective, and more and more retirees are looking for high-dividend stocks to boost their retirement income.
Two Common Types Of High-Dividend Stocks
The types of companies most often associated with income stocks are businesses that are not investing a lot in new growth and those that are required to distribute the majority of their income to investors for tax purposes.
Utility companies are an example of the former case. Because they are typically granted monopoly privileges by municipal governments, their customer base is fixed and they experience very little risk.
Therefore, they can afford to reward their investors by paying high dividends.
Other stocks pay high dividends due to the structure of the business. For example, Master Limited Partnerships (MLPs), mostly comprised of energy companies, are known as “pass-throughs.”
They are not required to pay corporate taxes because they distribute 90% or more of their income to investors through dividends.
Real Estate Investment Trusts (REITs) and Business Development Companies (BDCs) are two more types of stocks that are required by law to pay a high percentage of their earnings directly to investors.
What To Look For In A Dividend Stock
Revenue And Pricing Power
There are several things to look for in a dividend stock besides the percentage it pays. First of all, make sure to invest in a company with a reliable and predictable source of income.
A business that only thrives when the economy is strong is a risk because a downward shift in employment, for example, could hurt the business’s profits and decrease the dividends it pays.
Look instead for companies that sell essential products and services with little competition.
Proctor & Gamble is one example of a company that sells basic consumer products with highly reputable brand names (Pampers diapers and Tide detergent, to name just two) that have earned solid customer loyalty over the years.
With a strong reputation and customer base, the company can sell at a high price without fear of competition. P&G stocks are one of just ten DOW stocks that are currently paying above 3%.
It’s also a good idea to invest in stocks that are not paying out too high a percentage of their income in dividends.
If the ratio is too high, then the company may need to cut dividends in order to cover its costs. A ratio above 100% would indicate an unsustainable payout and thus a high risk to the investor.
A ratio of 0%, on the other hand, indicates a negative income and thus a stock to avoid. To calculate a stock’s pay-out ratio, divide the dividends per share by the earnings per share.
Alternatively, you can divide the total dividends paid out by the company’s net income. Conservative investors typically prefer a ratio of 70% or less.
Other similar metrics to look at include the price-to-earnings (p/e) ratio, and debt-to-equity ratio. Both of these measurements indicate how healthy the business is and how likely it will be to maintain high dividend payouts over time.
Companies with low p/e and debt-to-equity ratios are likely to be safer investments for similar reasons; they indicate that a company is earning enough to cover its debt and expenses and will not have to decrease dividends or limit increases.
How To Minimize Risk
While risk is an unavoidable aspect of investing, income investors are especially concerned with minimizing it.
First of all, be aware that many high-dividend stocks are paying out the majority of their profits to investors, meaning that they must continuously raise outside capital through debt and sales of stock shares in order to grow.
When outside financing becomes too expensive, these companies may be forced to cut back their dividends.
These companies are also vulnerable to government regulations that could increase their tax burden and limit their profits.
It’s also important to look closely at high-dividend stocks in order to avoid a trap. If a business’s stock price goes down faster than its reported earnings, its p/e ratio can look artificially low and its dividend payments may not actually be sustainable.
Expert income investors recommend sticking to an industry that you understand well so that you can accurately interpret information about a business or sector.