Investing for capital gains is a great way to play the stock market game. High growth stocks like newly blooded start-ups and clinical-stage pharmaceutical companies have always been seen as a means to making big returns in a short space of time.
But this approach comes with its own set of unique risks. Not all companies realize the high hopes that investors put in them at the beginning, and over the long-term this method doesn’t always pan out as planned.
There is, however, another way – and that’s with dividend investing. Rather than being rewarded with an increase in a company’s market value, dividend stocks offer investors a reliable and predictable income in return for the shareholder’s loyalty.
Firms benefit because people are incentivized to hold on to their shares while receiving a dividend, as well as the fact that a company is more attractive to investors when the stock pays out a quarterly income.
Which Stock To Pick?
It’s not always easy knowing which dividend stocks are the best to invest in, but there are some fundamental pointers that can help.
One of the most important metrics to consider when choosing dividend shares is the dividend yield. The yield tells you what fraction of a stock is returned to investors in the form of its annual dividend. The average yield an income-oriented investor strives for is generally 4%.
Many investors like to find a stock that outperforms the market average in a bid to maximize their dividend income. One company that does this is communications giant AT&T Inc. (T), whose forward yield is a massive 7.66%. For anyone wanting to pull in a quarterly dividend of $1000, they’d need to buy 1,923 shares of AT&T, a total investment of $52,219 at today’s current share price.
The dividend yield isn’t the only metric to worry about, however. For a dividend investment to be worthwhile over the long haul, you need to be confident that the company you invested in is able to maintain its dividend payments in the future.
In this regard, it helps to look at a firm’s payout ratio too. The payout ratio is a percentage figure that tells you how much of a company’s earning are going towards paying for its dividend obligations.
This metric is actually pretty crucial because it shows whether a business can actually afford its dividend payments of not: a payout ratio over 100% means that a company is paying out more in dividends than it makes in profits – something which is normally not sustainable long-term.
AT&T’s payout ratio is fairly good; the company only had to use around 57% of its free cash flow (FCF) to cover its dividend over the last year, meaning that it wasn’t struggling to find money to reward investors.
Payout ratios in the range of 40% – 60% are usually seen as being OK for a company – and while T’s ratio is at the higher end of this, it’s not an immediate concern.
Should You Buy An Aristocrat?
Another important thing to think about with income investments such as dividends, is whether or not your payments will increase over time. Inflation can erode away the most iron-clad investments, and it’s critical that your dividend doesn’t languish behind.
To mitigate this, many investors like to focus on what are called “Dividend Aristocrats” – companies that have a history of annual dividend increases that go back at least 25 years. As AT&T has consistently paid and upped its dividend payout for 35 years now, it definitely qualifies as a Dividend Aristocrat.
Even if a company does increase its yearly dividend in absolute terms, its yield could still go down. This can happen when a stock rises in price faster than its dividend, making the yield as a fraction less than it previously was.
For investors that just buy their shares once and never sell, this isn’t really an issue; but many investors re-invest their dividends back into the company, taking advantage of compounding effects to maximize returns. While this will still be beneficial, if the yield falls over time the results will not be as lucrative as before.
Don’t Ignore A Company’s Performance
Although AT&T is a Dividend Aristocrat right now, that accolade will fall next year, after the company announced recently the spin-off of its previous Time Warner and DirecTV acquisitions.
Having made a couple of bad deals over the last decade, AT&T decided to restructure and merge the two companies into other businesses, in an attempt to make the brands more profitable. However, because AT&T will now have less FCF after the mergers, it made the move to cut its dividend to reflect the company’s altered cash position.
AT&T is expected to resize its dividend to around 40% of its newly reduced FCF, which is forecast to be about $20 billion. This will give a total dividend payout of ~$8 billion, which at its present share price of $27 implies a yield of roughly 4.3%.
Despite this short-term negative outcome, it’s not all doom-and-gloom for investors. AT&T is making these changes for the good of the company as a whole, and there’s no reason why its dividend can’t become even more competitive in the years to come.
The way to dividend riches is a well-trodden path, one in which investors would be wise to follow the tried-and-true methods of others in generating high quarterly returns of $1000 and more.
Look for good yields, reasonable payout ratios – but never forget: you’re investing in the success of a real-world business – and the health of a company should always be your first concern.
The author has no position in any of the stocks mentioned. Financhill has a disclosure policy. This post may contain affiliate links or links from our sponsors.