The stocks that pay the highest dividends are traditionally some of the riskiest income investments around. For example, a company that offers a double digit yield may actually be in financial trouble. This is because the dividend yield calculation is often a lagging indicator. Since the yield is calculated using the annual dividend payout and the current share price, it can take several months for a yield to correct itself. This is why the highest dividends may not always be the best investment choice.
Stocks that pay the highest dividends don't actually need to have a double digit yield. In fact, the best dividend paying stocks actually have a yield that is less than 6%! There are plenty off other factors like annual dividend increase that play an important role in defining the best investment options.
Identifying certain criteria and guidelines can really help investors find the lowest risk stocks that pay high dividends. Highlighted below are a few tips that can help weed out the bad dividend stocks from the good ones.
5 Tips for Investing in Stocks that Pay the Highest DividendsHere are a few tips investors may want to use when researching the highest dividend paying stocks. Being able to filter out the poorly run companies is critical to the success of an income investor.
- Look at Dividend History - Does the company have a solid history of raising dividends each year? A company who has raised their dividends for over 25 years is more than likely a safer investment than one that has only a few years. While not a predictor of the future, the historical dividend performance of a company is very important.
- Dividend Payout Ratio - How much does the company payout in dividends compared to earnings? A stock that has a payout ratio above 50% - 60% of their earnings will probably not be able to sustain their current yield. Look for early warnings signs in a stock based on this equation.
- Dividend Yield - As mentioned earlier, the dividend yield can be used to determine the current rate of return for a stock compared to its share price. Investors should be cautious, however, using just the yield as an indicator to invest in a company. Stocks that pay the highest dividends are not necessarily the best investment options.
- PE Ratio - Not a direct dividend calculation, the PE ratio (price per earnings) is an important financial indicator of the company. A solid blue chip investment should not have a PE too much above 20. Anything higher is an early indicator that the stock may be overpriced and set for a correction.
- Yield on Cost - Once an investor has established a position in a stock, they should account for their yield on cost. Even though a solid dividend performer may have a current dividend yield of 5%, it doesn't mean that is what all investors are earning. If an investor has purchased the stock well above the current share price, then their yield on cost will be lower. Over the period of several months (or years in some cases), an investor should make sure they are earning a respectable yield based on their average purchase price.
Investing in stocks that pay the highest dividends isn't always a smart investment. Often times, novice income investors chase the stocks with the highest dividend yield which can lead to trouble. Most companies that have very large yields (i.e. above 6%) may not be able to maintain their current yield. Using a variety of calculations and historical data is the best way for an investor to find the best dividend paying stocks, not just the highest ones.