Should You Invest in the Highest Dividend Paying Stocks?

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Stocks that pay dividends can be great to own, but chasing the highest annual payouts may cost you in the long run. Here

A successful company—one which earns real money every year has three options. It can reinvest those earnings into the company to make new products, find more customers, build new stores or factories, or make the business more efficient. It can buy back its stock so that each remaining share owns more of the company (and more of next year's profits). It can return some of that money to shareholders in the form of dividends. As part of learning how to invest in stocks, you need to understand how dividends work.

How Do Dividend Paying Stocks Work?

Think of dividends like interest on a loan. Suppose you loan your best friend $1000 for a year at 5% interest. You expect to get back your $1000 plus that 5%—another $50. A dividend is sort of like that, except the $1000 stays in the company because you still own part of it. It's your portion of the profit the company made.

Not all companies pay dividends. Some companies make no profit, so they can't pay out anything (without taking out a loan). Other companies pour all of their money back into the company to grow faster. That's a reasonable choice. What works for one business doesn't work for others.

Why Invest to get Dividends?

Some people like receiving dividend checks. A reliable company like Coca-Cola pays out handsomely every quarter. Even if the share price barely moves every year, investors still make money from these dividend payments. Better yet, they don't have to sell their shares to get that money. The check comes every quarter.

This money gets paid to all shareholders, regardless of the number of shares they own. A retired grandmother in Canada who owns one share of Coca-Cola gets her dividend the same way a wealthy hedge fund manager who has a fifty million dollar portfolio and lives on the beach in Costa Rica does. That's why dividend investing is attractive: it's reliable.

High Dividend Stocks

Of those stocks which do pay dividends, it's common to see payments of about 2% of the value of the stock every year. In other words, if the stock costs about $100, the dividend you get per share will be about $2 every year. That's a 2% return on your investment, before taxes and fees. (Once you take into account federal and state income taxes and inflation, a 2% annual return doesn't sound like much, does it?)

Some stocks pay no dividends, of course, but high dividend paying stocks may have rates of 5%, 10%, or more. Why so high? A company with a share price of $10 which pays a dividend of $1 per share every year has a dividend yield of 10%, while a company with a share price of $100 which pays out $1 per share every year has a dividend yield of 1%.

Yet before you snap up penny stocks that pay dividends (low prices, high dividend yield), remember that the price you pay for a stock and the growth of the business over time govern how much money you make on that stock. Also keep in mind that you will rarely see penny stocks pay dividends! (There's no shortcut to invest little money with high returns. Sorry.)

Does a Stock Pay Dividends?

The easiest way to tell if a stock pays dividends is to look at any stock research site, like Google Finance or Yahoo! Finance. You should see a dollar amount for latest dividend announced, annual amount paid, and current yield. Check these dates; a stock may pay out one quarter and not the next.

Should You Invest in the Highest Dividend Paying Stocks?

Not necessarily! A high dividend paying stock is paying more than the average dividend rate (if you look at all stocks that pay dividends they pay, on average, 2 or 2.5% annually). Perhaps you've found a company which pays much more. Companies that pay high dividends may do so because they're good companies... or because they want to attract investors to drive up the share price. It may be a sign that the share price has gone down, dramatically down, recently. (Sometimes this means the stock is on sale! Great! Other times it means that the company is in trouble.) You can't know this just by looking at the share price and the high dividend amount; you have to understand the company's business and its current financials.

Keep in mind that a company must choose to pay a dividend. Just because it paid one last quarter doesn't necessarily mean that it will pay one this quarter. As well, the amount paid may very. While a reliable dividend stock like Coca-Cola will regularly raise the amount of its dividend payments, not all companies do. A fluctuating business which paid $1 per share last year may pay only $0.02 per share this year.

Are Dividends the Right Thing to Pursue?

Investing in stocks that pay dividends can be a good strategy, especially if you want regular cash coming in reliably. Remember that word, reliable.

Reliability is more important than a high payout. Dividends aren't guaranteed. A company that paid a huge amount of money last year but may not pay it again this year isn't necessarily worth owning. You still have to do your research. You still have to buy great companies, not just stocks that pay the highest dividends per share.

Are high dividend stocks a good investment? Not necessarily! Pay attention to how they're paid. Do they pay them every year? Every quarter? Does the company raise its payment amount on a regular schedule? The best dividend paying stocks do this. Coca-Cola is a great example; Coca-Cola stock is a good investment, though it's not always available at a great price! If you bought Coca-Cola at a great price a couple of decades ago, you could make more from dividends every year per share than you ever paid for the stock. (That's the misleading part of dividend yield of stocks; it's always calculated relative to the current price, not what you paid.)

Can the company even afford to pay out this year? How about next year? A company that pays a huge dividend—especially one disproportionate to its earnings and free cash flow is a warning sign. How does the company plan to continue its payment strategy? Is this a temporary trick of accounting to draw in uncautious investors to inflate the stock price to artificial levels? Be wary. Rely on reliability.

Should Value Investors Make Money from Dividends?

Dividends are great, and many great companies have good dividend stocks to buy. Yet value investing looks for underpriced stocks. Sometimes they pay dividends. Sometimes they don't.

If you find yourself asking "What are the best stocks to invest in?" or "What are the reasons to invest in a company?", dividends may be a sign of a good stock. Not all great stocks pay dividends, though. Some never do. Some pay sporadically. It depends.

If you find a great company that gives you a check every quarter—and if the price is right relative to the value—then you've found a true gem.

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