With even 30-year Treasury bonds only yielding around 2.3%, investors looking for income from their portfolios have to look farther out on the risk curve than government bonds to get decent yields. Those low yields are making stocks — which often not only pay higher-yielding dividends but also have the potential to raise their dividends over time — look that much more attractive by comparison.
Still, investing in dividend stocks requires much more than just looking for high yields. Indeed, searching for stocks just based on their yields is a great way to lose money, as the stocks with the highest reported yields are often ones most at risk of cutting their dividends. If you want a smarter way than just searching on yield to find income-producing stocks, these three dividend investing tips can help earn you thousands.
No. 1: Look at the company’s payout ratio
A company’s payout ratio shows how much of its earnings it pays out in the form of its dividend. In most cases, what you’re interested in is a payout ratio in the “Goldilocks” zone. Too low of a payout ratio, and it’s often a sign the company either doesn’t prioritize its dividend or that it feels its earnings are too volatile and at risk to justify a larger dividend. Too high of a payout ratio, and it’s frequently a sign that either the dividend is at risk or the company is sacrificing growth opportunities to make the payment.
Where does that Goldilocks zone sit? Well, it depends in large part on what type of company you’re investing in. For most standard companies, a payout ratio somewhere in the range of 25%-75% is reasonable. For a few specific types of specialized companies, such as real estate investment trusts and limited partnerships, a higher payout ratio may very well make sense. This is because those specialized companies follow tax rules that pretty much require high dividends.
Real estate investment trusts must pay out at least 90% of their qualifying income as dividends, and in exchange, they can “pass through” that income without paying a corporate tax on it. Similarly, the holders of limited partnerships are taxed on the partnership’s earnings as their own income regardless of whether they receive it as cash. As a result, limited partnerships also tend to offer high yields. Even so, you’ll want to make sure their dividends are covered by the business’ cash flows before investing.
Learn more about: 3 Dividend Investing Tips That Can Earn You Thousands