Why and How to Invest in Dividend-Paying Stocks

No matter what your stage of life, dividend stocks can be a valuable way to supplement your income and improve your portfolio growth potential. 

For example, investors who are many years from retirement often reinvest their dividends to boost returns. In fact, a hypothetical $10,000 investment in an S&P 500^® index fund at the end of 1993 would have swelled to more than $182,000 by the end of 2023 had dividends been reinvested, but only to $102,000 had dividends not been reinvested.

For retirees, regular payouts from dividend stocks have the potential to provide a steady stream of income. And while dividend yields from S&P 500 companies may have declined over time, it's important to consider that in the context of inflation. 

Not all companies pay dividends, of course. Smaller, less-established companies, which may often provide above-average returns on the value of their stock, can justify reinvesting in themselves rather than paying dividends to shareholders. 

Larger and more-established companies, by contrast, tend to see slower growth and lower returns, and they typically pay dividends to help retain existing shareholders and attract new ones. Indeed, of the approximately 500 large-cap stocks tracked by the S&P 500, more than four-fifths were dividend stocks as of late 2024.

What's more, dividends aren't guaranteed, unlike the interest payments from Treasuries. Companies can trim or slash their dividends at any time, a risk that was realized in 2020 after 68 of the roughly 380 dividend-paying companies in the S&P 500 suspended or reduced their payouts.

There are many reasons why a company might pay dividends, but usually it comes down to being a mature business with fewer alternatives for investments within the firm. You don't see many dividend-paying companies in near-startup mode or in high technology, simply because they have many opportunities to invest. 

Dividends are determined on a quarterly or annual basis and a company typically pays a cash dividend directly into a shareholder's brokerage account (other forms of dividends are paid in stock). Dividend yield, calculated by dividing the annual dividend by the current stock price, is one key metric that helps investors understand the return they might generate on a stock and get a sense of how various dividend-paying stocks stack up against each other.

Consider a simplified example: For a company that pays a 2% annual dividend and whose shares are trading at $100, an investor with 100 shares would receive an annual dividend payment of $200 (2% of one $100 share = $2; $2 x 100 shares = $200).

Dividend yields for many of the largest U.S. companies tend to be lower than that example. As of October 2024, the average dividend yield of S&P 500 companies was 1.25%, well under recent inflation levels and Treasury yields.

When it comes to investing in dividend stocks, many investors turn to mutual funds or exchange-traded funds that offer access to dividend-paying companies across industries.

Those who prefer to hold individual stocks might instead want to follow in the footsteps of famed investor Benjamin Graham, who favored companies with three attributes:

1. A history of steady dividend growth: Consistently increasing dividends are generally an indicator of healthy corporate fiscal policy.
2. A low payout ratio: When companies exhibit a low ratio of dividends to earnings, it suggests they're retaining some earnings, making it less likely they'll reduce dividends in the future.
3. A respectable current dividend rate: According to research by Robert D. Arnott and Clifford S. Asness, low dividends beget lower stock prices, while high dividends beget higher stock prices.¹ However, unusually high dividends can be a sign of corporate distress. So, a good rule to consider is to look for dividend stocks yielding at least as much as the current 10-year Treasury note (TNX) yield but no more than twice that amount.

There's a reason—and not always a good one—that a security is offering payouts that are well above its peers or the broader stock market. Before jumping at a big yield, try to determine why it's so high.

Dividend yield is calculated by dividing a stock's total annual dividend payouts by its current share price. If a high or rising yield is due to a shrinking share price, that's a bad sign and could indicate that a dividend cut is on the horizon.

If a rising dividend yield is due to rising profits, on the other hand, that's a much more auspicious sign. When net profits rise, dividends tend to follow suit, so just be sure you know what's causing the increase before buying the stock.

This metric—which is calculated by dividing dividends per share by earnings per share—tells you how much of a company's earnings are going toward the dividend. A ratio higher than 100% means the company is paying out more to its shareholders than it's earning. In such cases, it may be able to cover its dividends from available cash, but that can last only so long.

If a company whose stock you own is losing money but still paying a dividend, it may be time to sell. Dividend payers in financial straits may try to stave off a dividend cut—which can drive away shareholders—by funding payouts with borrowed funds or dwindling cash reserves. It's rare that such measures turn things around, though. They're usually just delaying the inevitable.

High levels of debt represent a competing use of cash. If push comes to shove, the company is going to pay its creditors before it pays its dividends.

A good rule to consider is to favor companies with a "current ratio"—a measure of the company's current assets versus its current liabilities—of 2 or higher, which is a good indicator of its ability to cover its short-term obligations.

Generally speaking, you want to find companies that not only pay steady dividends but also increase them at regular intervals—say, once per year over the past three, five, or even 10 years. Indeed, companies that grow their dividends tend to outperform their peers over time.

A 2024 survey of global fund managers by Bank of America (BAC) showed them evenly divided when asked what they'd like companies to do with their cash flow when the choices were to increase capital spending, improve balance sheets, or return cash to shareholders through dividends or buybacks. 

Though payouts can be helpful, especially if you're retired or living on a fixed income, you might want the companies you invest in to invest in themselves rather than sending money to your mailbox. Though there are no guarantees, companies that retire debt or increase capital spending can sometimes put themselves into position to improve profits. Higher profits, if achieved, often translate to a higher stock price, which in the long run would benefit investors.

That said, no investment vehicle is perfect. Dividend stocks are subject to the same vicissitudes as all other equities. And unlike bonds—whose coupon payments are nearly guaranteed, barring default—dividend payouts could be trimmed or eliminated altogether without warning.

All of which is to say that dividend stocks should not be viewed as a replacement for traditional fixed income investments but rather as a complement to a diversified portfolio.