Dividend stocks can be a great addition to your portfolio. On top of the cash they provide, dividends offer other benefits to long-term shareholders. Chief among them are the discipline that dividends enforce on companies' managements and the signaling power they provide regarding what those management teams really think about their companies' prospects.
Still, there's more to successful dividend investing than simply looking for the biggest dividends you can find. Keep reading to learn about some key things to look for in determining whether a dividend-paying company might deserve a place in your portfolio or whether it's one you might want to avoid.
Dividend-paying companies within a given industry tend to have similar dividend yields, and a company with a very high yield compared with its peers may very well be what's known as a dividend trap. That's a company that the market believes won't be able to maintain its dividend because of underlying financial troubles.
STON , for instance. Yet it's losing money, and Moody's recently put a negative outlook on its debt rating, which already sits well in the "junk bond" range. Companies must prioritize their debt service ahead of their dividend payments, or else the bondholders can force a default and change of control.
SCI , which is both profitable and trades with a mere 1. Dividends are typically cash payments, and to make those payments, companies have to have the cash available. The only way that's even close to sustainable is for the companies to earn that money from their operations and then pay a portion of those earnings over to their shareholders.
A company's "payout ratio" measures how much of a company's earnings get paid to shareholders from its dividend. After all, companies need some flexibility to make sure they can cover unexpected expenses as well as their growth plans. That said, there are some companies in specialized industries that frequently pay out above that level, but they are the exception, rather than the general rule. Dividend-paying companies frequently attempt to increase their dividends over time as the profitability of their businesses allows.
What gives Enbridge the confidence to announce that goal is that its primary business is moving energy around through pipelines, making it essentially an energy toll road. As the political flak over things like the Keystone XL pipeline expansion shows, it's hard to get approval to build pipelines. Once that approval is granted, it still takes a lot of capital to actually build. That combination gives existing pipeline operators such as Enbridge a fairly high level of confidence in its future earnings growth potential.
In addition, Enbridge recently completed the purchase of U. Dividend stocks whose payouts are well covered by their earnings and that have the opportunity to increase their dividends over time can play an excellent role in your portfolio. Just make sure you're not overly tempted by high-yielding dividend traps. It's the total package that matters, not just the current yield. Instead, focus on fundamentally strong businesses with the operating strength to maintain their dividends and enough buffer to handle the unexpected twists the economy throws their way.
That way, you'll be more likely to own the strong companies that can make dividend stock ownership an ultimately profitable endeavor. Chuck Saletta owns shares of McDonald's and his wife owns shares of Enbridge. The Motley Fool owns shares of and recommends Enbridge. The Motley Fool has a disclosure policy. Chuck Saletta has been a regular Fool contributor since His investing style has been inspired by Benjamin Graham's Value Investing strategy. Chuck also can be found on the "Inside Value" discussion boards as a Home Fool.
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