With even 30-year government bonds yielding only about 2.3%, investors looking for income from their portfolios must look further on the risk curve than government bonds to get decent returns. The low returns make equities – which often not only pay higher returns but also have the potential to increase their dividends over time – look much more attractive in comparison.
Investing in dividend shares still requires much more than just looking for high returns. In fact, searching for shares that are only based on their returns is a good way to lose money, because the stocks with the highest reported returns are often the ones who risk reducing the dividend. If you want a smarter way than just searching for returns to find income-producing stocks, these three dividend investment tips can help you get thousands.
No. 1: Look at the company's payout ratio
A company's payout ratio shows how much of its profit it pays out in the form of dividends. In most cases, you are interested in a payout ratio in the "Goldilocks" zone. Too low a payout ratio, and this is often a sign that the company is either not prioritizing its dividend or that it thinks the result is too volatile and risks justifying a larger dividend. Too high a payout ratio, and this is often a sign that either the dividend is in danger or the company is sacrificing growth opportunities to make the payment.
Where is the Goldilocks zone? It largely depends on which company type you invest in. For most ordinary companies, a payout ratio somewhere in the range of 25% -75% is reasonable. For some specific types of specialized companies, such as investment in real estate investments and limited partnerships, a higher payout ratio may well make sense. This is because these specialized companies follow tax regulations that pretty much require high dividends.
Real estate investors must pay out at least 90% of their qualified income as dividend, and in exchange they can "pass" that income without paying a corporate tax on it. Similarly, holders of limited liability companies are taxed on the partnership's income as their own income, regardless of whether they receive it as cash. As a result, limited partnerships also tend to yield high returns. Still, you want to make sure their dividends are covered by the company's cash flows before investing.
No. 2: Look for a story with dividend growth
Dividends are not guaranteed payments and a company's board of directors generally determines its dividend based on the company's priorities and an expectation of its ability to pay it. If a company has good experience in increasing its dividend, it is a sign that its board of directors is serious about directly rewarding shareholders for the financial risks they take by investing in the business. This also means that if things go well, there is a chance that the dividend can be increased again in the future.
On top of the direct cash bonuses that come from a sufficiently covered and expanding return, a growing dividend can also signal what the company's management really thinks. After all, companies that lower their dividends often also look at their stock price, so they don't like to consciously raise their dividends higher than they think they can actually maintain it. So if a company says good things but just barely bumps its dividend, it's a signal that not everyone can be as good as it seems.
No. 3: See balance sheet
Dividends cannot be guaranteed payments, but bond yields and principal payments have a much higher priority for a company. If a company misses a bond payment, it faces default. The penalties for default can be as serious as loss of control of the company by its shareholders or even forced liquidation. As a result, if a company can make its bond payments, it will generally make its bonds, even if it means eliminating its dividend completely.
As a result, if you are looking for dividend as a source of income from your portfolio, you want to invest in companies with well-balanced balance sheets. Three important measures to look at include the interest coverage ratio, current ratio and debt to capital. They each look at different aspects of a company's ability to keep its commitments to its bonds. The stronger these conditions are, the better the chance that the company will also be able to support its dividend.
When you look beyond just returns, dividend shares can shine
In the long run, well-chosen dividend stocks can not only provide good income levels today but also the potential for excellent total return as well. Whether you are looking for higher investment income than you can get in even long-term government bonds or for the overall total return potential, dividend-paying shares may just be what you are looking for.
Still, to be successful, you have to look beyond what you see being offered as a company's dividend yield and the quality of business behind that dividend. If you are looking for companies that offer decent payouts, have reasonable results to increase their dividends in a sustainable way and have solid balance sheets, it improves your chances of choosing winners. And it can easily be worth thousands of dollars for your total portfolio.