This article was originally published on Fool.com. All figures quoted in US dollars unless otherwise stated.
The best dividend stocks give investors two vital things that they want in an investment. Current income can be helpful both for those who need to live off their investment portfolios and for those who like to have cash available to make opportunistic new investments. Meanwhile, dividend stocks also have the potential to see their prices rise over time, adding to their total returns.
Not every dividend-paying stock has the same attributes, though. If you look at dividend stocks as if they're all the same, then you can get caught in some painful traps. Here, we'll look at some different categories of dividend stocks that many investors gravitate toward, along with some tips for how to get the most out of them while avoiding potential pitfalls.
1. Dividend growth giants
Some of the most popular dividend stocks have long streaks of raising their dividends each year. The longest streaks now exceed 60 straight years of higher dividend payments, and you can find a good number of stocks with half a century or more of annual dividend increases.
However, before you jump into a stock just because it has a long history of rising payouts, you should look at some other key aspects. For instance, some of those long-streaked dividend growth stocks actually have yields that are quite low, not only compared to other dividend stocks but also to the overall market. Some stocks with long dividend streaks make token increases each year that extend their track record but aren't really meaningful in terms of providing more income.
2. Unsustainably high yields
Many dividend stocks have extremely high yields, raising the question among investors whether the stock can keep up the pace of its large payments. High yields can be a sign that a dividend cut is imminent, but some high-yield dividend stocks are able to keep making their payments for quite a while.
One thing to look at is how a company's dividends compare either with its earnings or with its cash flow. In some industries, earnings can be misleading, because large non-cash charges for items like depreciation affect earnings on an accounting basis but don't actually require the company to divert money from dividend payments. However, if neither earnings nor cash flow supports dividend payments, then you'll often find that a company is taking on debt to afford to pay shareholders, and that's something that most companies can't do for very long.
3. Dividends that companies have to make
Some companies are required to make dividend payments to meet certain requirements. For instance, real estate investment trusts benefit from not having to pay corporate-level income taxes, but to qualify for that treatment, they have to pay out the vast majority of their income to their shareholders in the form of dividends.
Investment vehicles like these often sport much higher yields than ordinary dividend stocks, but that's in part because they pay a larger portion of their earnings out to shareholders to meet these requirements. It's important to compare apples to apples in assessing yields of dividend-paying investments like these, or else you might draw the wrong conclusions.
4. Dividends that represent return of capital
Finally, some companies pay out as dividend distributions money that's more accurately described as being a return of capital. For example, royalty trusts typically make payments based on the production from their assets over a given time period. Eventually, though, the assets held by the royalty trust will be depleted, with no further production. In these cases, investors have to expect that the value of their royalty trust shares will trend toward zero over the long run, and so some of what they're getting as periodic payments needs to compensate them for the steady loss in value of their shares.
Be smart about dividends
Finding income from your investments is tough right now, and dividend stocks can be exactly what you're looking for to get income while also retaining some growth potential. By being aware of different types of dividend stocks, you can make smarter choices about which companies to add to your investment portfolio.
This article was originally published on Fool.com. All figures quoted in US dollars unless otherwise stated.
