How to invest in dividend stocks, a low-risk source of investment income

• Dividend stocks are shares of established companies that offer a predictable stream of income in the form of dividend payments.
• There are three common metrics to evaluate dividend stocks: Dividend yield, dividend payout ratio, and dividend payout growth.
• Investors look to dividend-paying stocks to generate steady income, or to build more wealth by reinvesting the dividend payments.

There are two main ways to make money in the stock market. One is to buy stocks and sell them later for a profit, or capital gain. The other is to buy stocks and reap income a little at a time via the dividends your shares pay.

Technically, any stock that pays a dividend - a piece of the company's profits - is a dividend stock. In common parlance, though, the term refers to a stock whose shares offer a steady, rich income stream, either to be used now or to be reinvested back into the company.

But how do you determine what's a "good" dividend stock? There are several ways to evaluate them.

Dividend stock basics

Dividends are small per-share income payments of a company's earnings or profits to stockholders. The higher the payment and the more shares you own, the more income you receive. The more profitable the company is, the higher the dividend - in most cases.

The best dividend stocks are also often known as blue chips, representing large, solid, well-established companies that pay the same or similar annual dividend year after year. Some examples include General Mills, Inc. (GIS), ABBVIE Inc. (ABBV), and Duke Energy Corp. (DUK).

Dividend stocks often overlap with another equities type: defensive stocks. These are companies who perform well in good economic times and bad - both bull and bear markets.

Dividend stocks are most often contrasted with growth stocks. These usually represent small but fast-growing companies that offer great appreciation potential - down the road. In the meantime, they're plowing most of their profits back into production and operations. So their shares don't offer much (if any) of a dividend payout.

That being said, not all dividend stocks come from venerable, giant corporations, and not all growth companies are young. Perhaps the most famous case in point is Amazon (AMZN). Although huge, an industry leader, and over 20 years old, Amazon still invests most of its profits in research and development, instead of offering dividends. And its share price continues to rise. So financial analysts still classify it as a growth stock.

How to evaluate dividend stocks

Evaluation is key to picking dividend stocks that will offer solid income over the long term. Three important metrics can help you choose the best dividend stocks for your portfolio: dividend yield, dividend payout growth rate, and dividend payout ratio.

Dividend yield

The most important metric is dividend yield, a ratio expressed as a percentage that shows how much a company pays in dividends relative to its share price.

For example, if the annual dividend paid by a company is $5 and the price of a share of stock is $100, the dividend yield would be 5/100 * 100 = 5%.

In most cases, you won't have to calculate the dividend yield for a company. Just check the stock listings page or market index page like this one for AT&T (T), and scroll down to dividend yield.

Numbers to look for: Between 2010 and 2020, the average S&P 500 dividend yield has been 1.96%. So, historically, a dividend yield between 2% and 6% is considered good. Blue-chip stocks, like AT&T, often are even higher.

Dividend payout growth

The dividend payout growth, also known as dividend growth rate (DGR), is the average percentage rate of growth a stock's dividend has experienced over a specific period (usually three, five, or 10 years). It's a key metric to help you stay ahead of inflation, which has averaged 1.67% over the past 10 years.

For example, if a company's annual dividend this year is $10 and the annual dividend last year was $9, the one-year dividend growth rate would be calculated as follows: 10/9 - 1 * 100 = 11%.

Numbers to look for: A DGR of 5% to 9% is considered good and anything over 10% very good.

Dividend payout ratio

Finally, look at the dividend payout ratio, or the percentage of a company's earnings or free cash flow used to cover dividend payments.

For example, if the annual dividend per share of a company is $5 and earnings per share (EPS) are $10, the payout ratio would be 5/10 * 100 = 50%.

The payout ratio is important because it tells you whether a company is dedicating too much (or too little) of its free cash flow to dividends. For the S&P 500 between 2010 and 2020, the average dividend payout ratio has been 41%.

Numbers to look for:

• 0% to 35% is the mark of a young company just starting to pay dividends.
• 35% to 55% is a sign of a healthy, mature company that has struck balance between dividends and reinvestment.
• 55% to 75% would be considered high since more than half of profits are going toward dividends. Note: Slow-growth blue-chip stocks may have a higher payout ratio than younger companies.
• 75% to 95% or higher may mean the company is borrowing to pay dividends, a sign a dividend cut or suspension may be in the works.

Other things to consider

Before you reject a stock because it doesn't have the "right numbers" on all three metrics, consider how those metrics work with and against each other.

Match the metrics to your investing style

The relationship between metrics will help you decide if a stock is not only a good dividend stock but whether it's good for you. If you are just starting out, you may prefer a high dividend growth rate, even at the expense of dividend yield or payout ratio. On the other hand, if you are near retirement, growth won't be as important as yield and payout ratio.

Dividend yield vs. dividend growth rate

A high dividend yield may signal a company that's not destined for a lot of growth. That's because high yield typically comes from established but slow-growing companies, churning out lots of profit. The opposite is also true. If yield is low but DGR is high, you might be in the beginning stages of a company whose stock will pay off down the road. So, the question may be, "Do I want short-term profit or long-term gain?"

The role of dividend payout ratio

Which brings us to the percentage of earnings being paid out in dividends. The reason 35% to 55% is considered optimum is that it helps guarantee the company isn't over-extending itself or (shades of horror) borrowing money to pay dividends. But, as with both DY and DGR, circumstances matter.

A DPR of 60% or even 70% may be perfectly reasonable for a solid-slow growing company with no need for a lot of R&D or a company on the cusp of new income. Likewise, a dividend payout ratio under 35%, especially if the DGR is high might be a signal you could get in on the ground floor of a great opportunity.

Advantages and disadvantages of dividend stocks

As with any strategy, there are advantages and disadvantages to dividend investing. Your age, investment goals, and tolerance for risk will help you decide whether the upside outweighs the downside.

Pros of dividend stocks

• Reliable income stream
• Less volatile than other types of stocks
• Potential double payoff: dividends now, appreciation later

Cons of dividend stocks

• Dividend amount not guaranteed
• Less growth than other stock types
• Limited diversity: most stocks in old-line industries

The financial takeaway

Dividend stocks are those that offer the right combination of yield, growth, and payout ratio.

In addition to the obvious benefit - cash - investors like dividend stocks for two main reasons:

1. They represent safe, well-established companies with a track record of sharing profit with stockholders.
2. They require very little maintenance because, once you've picked them, dividend stocks are mostly "buy and hold."

Dividend stocks appeal especially to older investors because of the regular, paycheck-like income stream. However, whether you are just starting your investment journey or nearing retirement, part of your portfolio can benefit from owning dividend stocks, as a good diversification technique.

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