The Income Approach to Dividend Investments

By Lawrence Carrel

Among stock investors, income and dividend investing are one and the same; the income investing approach encourages you to buy investments, such as stocks or bonds, that promise a steady stream of income.

For most of history, investing was income investing. Whether investing in stocks or bonds, in small or large businesses, investors needed income from their investments to cover their daily expenses. They simply didn’t have the surplus cash on hand to let it sit in the market for several years until they could sell and reap their profit.

When you’re investing for income and looking for a relatively safe and steady cash flow, you have several options (in addition to investing in dividend stocks). These options include ranging savings accounts, money market accounts, certificates of deposit (CDs), and bonds.

The main attraction of most conservative, income-investing options is that they help protect your principal — when the game is over, you can expect to walk away with at least as much money as you started.

When you’re focused on income investing, particularly through dividend stocks, three criteria step into the spotlight:

  • Yield is the percentage return on your investment you see exclusively from dividends. If you buy shares for $20 each and the company pays $2 per share for the year, the yield is 10 percent: $2 / $20 = 10 percent. When you’re investing solely for income, make sure the yield is greater than the inflation rate; for example, if inflation is at 3 percent, eliminate most stocks yielding less than 4 percent.

  • Payout ratio is the percentage of its profits a company pays out as a dividend to shareholders. Anything over 50 percent is good. Most companies pay between 50 and 75 percent. Higher is usually better, but anything more than 100 percent is a red flag because it means the money is coming from someplace other than profits.

  • Dividend growth demonstrates a company’s ability to earn ever-increasing profits and share ever-increasing dividends with shareholders. Dividend growth is just as important as, if not more important than, yield. A low-yielding stock with a steady stream of increases may be a better investment than a high-yielding stock that hasn’t increased the dividend in years.

For all the extra risk you accept with the purchase of dividend stocks, you receive a huge benefit: the potential for income growth from a steadily increasing dividend. This advantage can be more important than a high yield because every time the dividend increases, the yield on your initial investment increases. If you buy a $10 stock with an annual dividend of 20 cents, you receive a 2 percent yield. If the company increases the dividend by a nickel every year, after four years the yield on your initial investment will have doubled to 4 percent.