How To Select The Best Stocks That Pay You Cash
When it comes to buying shares of stock, I’ve always been partial to dividend stocks. By paying a dividend, the company has some level of accountability to its shareholders. And the income you receive from dividends is yours to keep forever – regardless of whether the stock price moves higher or lower. Today, we’re going to cover some dividend basics that will help you pick out the best dividend stocks.
I’ll show you how to measure how well you’re getting paid for your investment, how to determine the reliability of those payments, and how to keep more of the income that you earn.
Editor’s Note: This is part five in our multi-part series on fundamental investment principles. See also:
- Part I – What is a Fair Price to Pay For My Stock?
- Part II – Are you a Growth Investor or a Value Investor?
- Part III – How to Know Which Stocks to Buy (and When)
- Part IV — When Should You Sell Your Investments?
You can always email me (Zach@ZachScheidt.com) to let me know what additional fundamental questions you have about investing.
How Much Am I Really Getting Paid?
I love owning dividend stocks because of the reliable payments these companies automatically deposit into my account. As I plan my budget or retirement account, it is important to be able to understand how much each stock will pay me, and how that compares to other stocks that I could could invest in.
The first step is to look at how your company pays its dividend.
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The website Dividend.com is a great resource for this. You can input your stock’s ticker symbol at the top of the page, and see the size and frequency of the dividends this stock pays.
For example, one of my favorite long-term dividend payers is Procter & Gamble (PG). Below is a screenshot of the quarterly dividends that PG pays.
As a quarterly dividend payer, PG sends investors four dividend payments each year. Since each of these payments is for 67-cents per share, you can expect to receive $2.68 each year for every share of PG that you own.
So is that a good deal or a bad deal for you?
One way to put that number into context is to divide the total annual dividend payments by the stock price. This give you a “yield” (similar to an interest rate) that investors are paid.
Today, shares of PG are trading near $89. So if you take the $2.68 in dividend payments and divide it by $89, you get a yield of 3.01%.
This yield figure can be very helpful in comparing PG with other dividend stocks. For instance, Microsoft Corp. (MSFT) currently pays a dividend yield of 2.50% and General Motors (GM) pays investors a yield of 4.65%.
How Reliable Are My Dividend Payments?
While it is helpful to compare your dividend payments from different stocks, it’s also important to know how reliable these payments are. Also, many companies consistently grow their dividend payments over time.
So rather than look simply at a stock’s yield, it’s helpful to dig a bit deeper.
One important metric to consider is a company’s payout ratio. This measures how much of a company’s earnings are actually paid to investors via dividends.
In other words, if a company posts annual earnings of $5.00 per share, and pays annual dividends of $2.50, that company would have a 50% payout ratio. That’s because the company pays 50% of its earnings to investors via dividends.
Another important thing to consider is a company’s dividend growth history. This tells you if the company has a history of growing the dividends it pays to investors.
You can find both of these statistics at the top of the Dividend.com page.
Looking at both the payout ratio and a company’s dividend growth history gives you a better picture of how the company treats its shareholders.
For instance, think about a company with a long track record of growing dividends, and with a payout ratio of 45%. This company has the ability to continue to grow its dividends because earnings are well above the dividends paid.
On the other hand, if you see a company that has a payout ratio of 90% (or possibly over 100%), there is a good chance that the company will not be able to grow its future dividends. That’s because there isn’t enough earnings to cover a bigger dividend.
These are just two basic metrics to be aware of. You can find out more about a company’s dividend plans by researching earnings reports and listening to earnings conference calls.
Special Dividend Situations
Most dividend payments are taxed as “ordinary income.” So when you receive these dividends, you’ll be taxed according to your current tax bracket. Keep this in mind when deciding whether to buy your dividend stocks in a normal brokerage account, or in a tax-sheltered account such as an IRA or 401(k) account.
Some dividend stocks, have favorable tax treatment.
For instance, Real Estate Investment Trusts (or REITs), have some special advantages. These companies do not pay corporate taxes, which leaves more profits available for us as shareholders. In exchange for not paying corporate taxes, REITs must pay the vast majority of operating earnings to investors.
REIT dividends are taxed differently from normal dividends. A portion of these dividends are taxed as ordinary income. But part of these dividends are classified as “return of capital.” This portion of your payment is not immediately taxed. Instead, the “return of capital” portion is subtracted from your cost of purchasing your shares.
When you sell your shares, you’ll ultimately realize a larger gain (and be taxed for this gain). But that tax can be deferred (allowing your profits to compound over time). Plus, if you hold this position for more than a year, your profits should be classified as long-term gains (and taxed at a lower rate).
Similar situations for Limited Partnerships (LPs) and Business Development Companies (BDCs) help you keep more of the investment profits you generate.
Thanks for reading this series on fundamental investment principles. If you would like to know more about how to pick great investments, I recommend checking out a few of my top-ten investment books. You can get this free list of great investment books by signing up to my newsletter here.
Here’s to growing your income!