For all the bluster about stock market volatility, when you count dividends the S&P 500 has already surpassed its highest return on record. Unlike the interest from bonds, stock dividends tend to grow over time. So much so, in fact, that they have historically outpaced inflation.
Continued low interest rates have even the most conservative investors looking for higher yields. For many, high-quality, dividend-paying stocks can be a viable alternative. Dividend stocks pay out a portion of the company’s earnings for each share to shareholders, usually on a quarterly basis.
For example, if a company pays an annualized dividend of 20 cents per share, the company will send each shareholder a check for one-fourth of 20 cents (5 cents) for each share he owns at the end of each quarter. If you own thousands of shares, that can lead to a steady stream of income.
Younger investors often get into the habit of automatically reinvesting dividends paid out from stocks and mutual funds. After all, while you’re working and don’t need investment income, this provides a way to buy additional shares without actually having to contribute more money to your portfolio. Reinvesting dividends can help a portfolio grow substantially over time.
Traditionally, as older investors approached retirement they were advised to sell their stock holdings and reinvest those proceeds in lower risk and/or tax advantaged securities, such as corporate and government bonds. These days, however, retirees might wish to maintain a well-diversified portfolio comprised of both stocks and bonds. While bonds offer guaranteed income, low interest rates may not offer the level of income they need during retirement. Dividend stocks, on the other hand, can supplement that income. Retirees can simply choose to have their stock dividends distributed instead of reinvested.
Compared to more risky stocks, dividend-paying equities tend to have less earnings volatility and generally more dividend income contributing to their returns. There also is the advantage that many of these companies are well-established, long-respected members of the stock exchange, such as General Motors, IBM, Coca-Cola, Walmart, Kraft Heinz and Procter & Gamble.
Because no one can predict how well a company will grow in the future, it’s important to evaluate dividend-paying stocks in much the same way you would any stock purchase. First, assess the company’s level of cash flow, including revenue and earnings growth. This growth should be evaluated in consideration of its current debt maturities, pensions, tax obligations, capital expenditures and any other obligations that could impact its cash flow.
Next, consider whether its executive management team has a track record of returning capital to shareholders – if they haven’t done so consistently in the past, there’s no reason to think they will in the future, even if the stock looks like a good buy.
As always, consider your specific financial goals when crafting a portfolio. Reinvesting dividends over the long-term is a good way to grow your investment, while taking distributions during retirement could help supplement your income while still allowing for capital growth.