Dividend-paying stocks are a dependable way for investors to get paid during shaky market periods, when other avenues for profit, such as capital gains, are more uncertain. These stocks are considered to provide a hedge against inflation, making them popular investment choices in the current market. On average, they tend to be far less volatile than their non-dividend paying counterparts. A dividend stream that is reinvested and utilizes the power of compound interest can also be a formidable builder of wealth.
The
dividend yield, which is shown as a percentage, is a financial ratio that conveys how much a company pays out in dividends each year, relative to its overall stock price. Dividend stocks make an excellent addition to your portfolio, but they need to be assessed appropriately for them to be lucrative long-term investments.
How Dividends Work
Dividend payers are often larger, more established companies with ample cash reserves. They are not typically known for the rapid expansion and colossal growth that characterize younger, less established companies. However, they use dividends and their payouts to attract potential investors.
Dividends are a way for companies to pay investors a share of their profits. The dividends are paid out in regular intervals—monthly, quarterly, or annually—via cash or company stock. Due to this structure, many investors use dividend-paying stocks as an avenue for passive income.
A Hedge Against Inflation
The capital gains potential of a stock can be volatile, as many variables influence its performance. While some stocks can avoid the negative effects of a down market, the lion’s share does not.However, dividends are typically paid regardless of what the market is doing, and are regarded as much more dependable. For example, General Mills
(NYSE: GIS), the food-producing behemoth, has paid out dividends every year since 1898. Though its stock price has undoubtedly not risen every year since 1898, it has still paid out dividends to its shareholders, even in those down years.
Companies like General Mills, with a consistent and long history of paying dividends, tend to thrive during times of inflation. As product and service prices drift upwards due to inflation, so do the company’s earnings and dividends.
Over time, many companies with high-dividend stocks have realized the value of adopting business models that weather inflation. They even thrive when prices rise, subsequently fueling profits. Generally speaking,
companies in the food sector, such as General Mills, as well as companies in the energy and natural resources sectors, benefit from more robust pricing power and cost management. This allows them to hike prices while maintaining demand. The end result is a boost in profits.
Assessing the Dividend
While dividends can be a stellar addition to a portfolio, ensure that you vet them appropriately. The following points can help you accurately assess the vitality of a dividend-paying stock.
High Yields Can Be Deceiving: Many investors identify a group of the highest dividend-paying stocks and add them to their dividend portfolios. These then become an amalgamation of poorly vetted dividend stocks, which will not necessarily yield high returns. Resist the urge to do this.
While finding a security that offers a high payout can seem fortuitous, ask yourself why the payout is so high. If a company’s profits are increasing, the dividends should follow suit. If rising profits are the cause for a higher dividend yield, that is a promising sign. However, if the company has a diminishing share price and this is raising its yield, that is likely a red flag and the harbinger of an upcoming dividend cut.
Pay Attention to the Dividend Payout Ratio: The dividend paid to shareholders comes from the company’s profits and is called the
payout ratio. It is important to remember that all dividends paid out to shareholders equal money not being reinvested into the company. While high dividend yields certainly aren’t a red flag for a company if they can afford them, this is not always the case.
If the company is paying too high a dividend yield, it may be a sign that its leadership prefers not to reinvest back into the company. This could indicate that management does not believe in the potential for upside. It is something to which you should pay close attention. If the company lacks the ability to reinvest and grow its business, this should be a major red flag for investors.
Another potential red flag is if a company has a payout ratio higher than 100%. This means it is paying out more than it is earning. If this is the case, and the company is losing money but still paying out a dividend, it may be time to sell. A company may do this to avoid a dividend cut, which would undoubtedly scare away potential shareholders, although more often than not, it is delaying the inevitable.
Growth is a Great Indicator: When researching dividend stocks, finding companies that have consistently paid dividends in the past is essential. However, just as critical as consistent payments is finding companies that also increase their payout ratios at regular intervals. Historical data has shown that, over time, companies that grow their dividends typically outperform their contemporaries. Companies with a strong history of dividend growth have been shown to keep pace with inflation as well.
A Great Option if Assessed Correctly
If you’re seeking to supplement income and improve overall growth potential, dividend-paying stocks can be a stalwart addition to your portfolio. However, proper vetting of a company is imperative to avoiding dividend yield traps. This can be done by accurately assessing a company’s overall financial shape, as opposed to simply looking at its dividend yields.The Epoch Times Copyright © 2022 The views and opinions expressed are those of the authors. They are meant for general informational purposes only and should not be construed or interpreted as a recommendation or solicitation. The Epoch Times does not provide investment, tax, legal, financial planning, estate planning, or any other personal finance advice. The Epoch Times holds no liability for the accuracy or timeliness of the information provided.
