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How to Understand the Types of Dividend Stocks

When you start shopping for dividend stocks and evaluating candidates, consider targeting a specific dividend category to narrow the field. After identifying a few prospects that meet your minimum dividend requirements, you can then dig deeper into each company by using valuation, growth, liquidity, and solvency ratios.

Low-yielding stocks

In general, low-yielding stocks are those with a yield less than the average yield of the S&P 500 Index — currently 2 percent or lower. These yields are unlikely to keep pace with inflation.

You can find the yield on the S&P 500 on the Standard & Poor’s Web site. Under the heading Latest Standard & Poor’s 500 Market Attributes, click S&P 500 Earnings and Estimates. An Excel spreadsheet will appear; the yield is in the middle of the spreadsheet.

Don’t ignore low-yielding stocks and low payout ratios as a starting point for your research. A low payout ratio from a company just starting to pay dividends may show that the company is still reinvesting a considerable portion of its profits. Taking share price appreciation into account, a low-yielding stock may eventually outperform a high-yielding stock.

Steer clear of low-yielding stocks accompanied by high payout ratios. If the company is distributing 50 to 75 percent of its profits to investors and the yield is still below two percent, that’s not a good sign.

Medium-yielding stocks

Stocks posting yields between the average yield of the S&P 500 and up to 3 percentage points greater than the index’s yield are medium-yielding stocks, typically keeping pace with inflation and paying out between 30 and 50 percent of their earnings in dividends.

Investors usually buy medium-yielding stocks only if they expect to see share price appreciation as well as income.

The key issue when buying a dividend stock with a low or medium yield is income growth. You want to see a steady stream of dividend increases.

High-yielding stocks

High-yielding stocks are those with yields at least 3 percentage points higher than the average yield of the S&P 500 Index, which typically means higher than the inflation rate and returns from safer investment vehicles, including CDs and Treasury bonds. Companies that fall into the high-yield category are usually mature and have a limited growth potential. You can find them in a variety of industries, including utilities, energy, and real estate investment trusts. If you’re primarily an income investor, high-yielding stocks are the stocks for you.

Look for the sweet spots: high-yielding, undervalued companies where growth, income, and value all meet. Yield can increase as a result of an increase in dividend payment or a decrease in share price or both. A high-yielding stock can mean the shares are selling for less than they’re worth, signaling a potential buying opportunity. When management increases the dividend as the share price drops, they’re sending a message that they believe the share price will rise to a point at which the dividend is at an appropriate level. Buying the stock at this point may help you reap the benefits of both share price appreciation and high yield.

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