Dividend Stocks: a Passive Way to Grow Your Money

With such low interest rates, finding a decent yield can be tougher than old salami. Traditional government bonds don’t offer a high enough yield for most investors anymore. Extremely low interest rates force investors to look towards other slightly riskier options to find healthy returns. One of the best options right now are long-term dividend stocks. The dividends paid by these stocks get you an extra paycheck for no extra work, who doesn’t love free money!

What are Dividend Stocks?

A dividend  is when a company pays its profits out to its shareholders. Dividends are typically paid quarterly (every three months) and come with no stipulations. Usually only large well established companies pay dividends. A company is under no obligation to pay a dividend of a certain amount, but typically a good company’s dividend will grow or hold steady over time.

A long-term dividend stock is a stock that pays out a high dividend that the investor purchases with the intention of owning and collecting dividends from that stock for a long time. The size of a company’s dividend is measured by its dividend yield. Dividend yield is the percentage of the annual dividend compared to the stock’s price.  A stock that has over a three percent dividend yield is a high dividend stock.

However, it is important that investors don’t just pick the stock with the highest dividend yield without first taking a look at the company itself. Just like any other company you invest in you want to make sure your dividend stock company is financially healthy and has a durable edge over the competition. A good place to start looking is in the list of the 2016 dividend aristocrats . These are companies that have both paid and increased their dividends for long periods of time.

Warning Signs

While a high dividend yield is a good thing when picking a dividend stock, if the yield is too high you should become suspicious. If I see a stock with a 10% dividend yield I begin to ask questions. Is that sustainable? What is it that they are covering up that they are willing to offer me such a high yield?

If we look back to our article on the article on the 3 key ratios of value investing, when picking a value stock, we know that picking a stock with a negative earnings per share is a bad idea. The same rule applies to dividend stocks. How are they supposed to maintain their dividend (a payout of their earnings) if they aren’t earning any money? There are a few warning signs that we can look at to see which dividend stocks are good investments.

Another big warning sign is if a stock’s dividend drops. This is a sign that the company isn’t doing well, and a good indicator to get out of that dividend stock.

Payout Ratio

Payout ratio is a good number to look at to determine if a company’s dividend is sustainable. They payout ratio tells us how much of a company’s income is paid out as dividends. If a company is paying out all of its income as dividends it won’t have any money left for operations. You want to look for a payout ratio below 40%. A payout ratio below 40% tells us that the company is holding onto enough of its money that it will be able to continue operating and growing its business.

Bank Stocks

One of the first thing that you’ll notice when you start looking for dividend stocks is that a lot of companies in the financial sector will have dividend yields of 3.5-4.5%. The next thing you will probably notice is that all of these companies have extremely high debt to equity ratios. These high debt to equity ratios are not an indicator of a poorly managed bank.

In order to make money in the banking industry you have to carry a large amount of debt. Without high debt the banking business model does not work. Some investors will argue that since all banks carry high debt, high debt banks are not a bad investment. However, as we saw in the financial crisis of 2008, there is a risk of the stock collapsing if things go bad. I personally argue that I wouldn’t entirely rule out bank stocks, but keep in mind that the higher D/E does indicate higher risk. It is up to you to decide if the higher dividend yields are worth it to you.

Dividend stocks can be a great way to earn a higher return than bonds while still managing risk. The large companies that pay dividends are blue chips and usually safer than smaller companies. By reinvesting your dividends to buy more of that stock you can essentially earn yourself compound interest, which is a great way to build your wealth. In a low interest rate economy, dividend stocks let you earn a higher yield with minimal risk.

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