Why are dividends important?
Dividends are great because they provide stable income for investors, which makes them generally less volatile than the alternative class, growth, and can help them preserve capital during economic downturns. Companies like to hand out dividends because it’s a way to make their stock more attractive. Sometimes, it’s also good to return a portion of earnings to investors so that they don’t go on a company shopping spree and overpay.
Companies understand that cutting dividends will make their shares less attractive, so those that do hand out regular dividends often have fairly stable business models. These include utility firms, real estate investment trusts (or REITs), restaurants, and large blue chip stocks that aren’t likely to go out of business.
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The above chart shows four food companies that investors may want to investigate as a possible investment to their retirement account: McDonald’s Corp. (MCD), Yum! Brands Inc. (YUM), Brinker International Inc. (EAT), and Darden Restaurants Inc. (DRI). All of them provide higher yields than the popular Consumer Discretionary Select Sector SPDR ETF (XLY)’s 1.35%.
Key questions to answer
When searching for dividend stocks, these are probably the most important questions to answer.
Dividend yield matters to investors because it tells investors how much they can expect to receive in returns by investing in the stock. The higher the dividend yield, the better, because it could mean the stock is a bargain. But the price of a stock doesn’t just depend on dividend yield. Historic growth, which investors often use as a base for figuring out how much dividends will grow in the future, is also a factor.
Suppose company A and B trade at $10 a share in the market and both hand out $0.50 in annual dividend. This gives us dividend yield of 5%. But if company B’s dividend isn’t growing at all, while company A’s has been growing at 20% every year and are expected to continue to grow, then in two years, company A will be handing out dividends of $0.72. The investor in A will receive more cash from the company. To reflect the increase in dividends, other investors could be bidding up share prices of company A to $14.4 a share in order to keep the dividend yield stable.