During the bull market of the 1990s, dividends fell out of favor. With stock prices rising so dramatically, dividends didn't seem to matter. Historically, however, dividends have been a significant component of stocks' total return. For instance, from 1926 to 1985, dividends equaled approximately 49% of the total return of the Standard & Poor's 500 (S&P 500), with an average dividend yield of 4.8%. In contrast, from 1998 to 2004, the average dividend yield was 1.5%.*
A major reason for this dramatic shift was investors' preference for growth rather than income stocks. Growth companies tend to retain earnings to generate future growth, while more mature companies tend to pay out dividends.
But two factors may cause investors to shift their preferences back to dividends. First, the market volatility over the past few years has made the assured returns of dividends seem more attractive. After several years of decreasing or fluctuating stock prices, it can be comforting to count on dividend income. Second, since long-term capital gains and dividend income are now taxed at the same rates (5% for taxpayers in the 10% and 15% tax brackets and 15% for all other taxpayers), capital gains no longer enjoy a tax advantage over dividend income.
If you're thinking about adding dividend-paying stocks to your portfolio, consider these tips:
- Look for reasonable dividend yields.
Don't just search for stocks with the highest dividend yields. Like all stock investments, you want to purchase a dividend-paying stock with good future prospects. Dividend yield is calculated by dividing the dividends per share by the market price. A company with an exceptionally high dividend yield may be experiencing problems that caused a significant decline in price and may be forced to reduce dividends in the future.
- Make sure the payout ratio is reasonable.
The payout ratio equals dividends per share divided by earnings per share, indicating how much of a company's profits are used to pay dividends. A general rule of thumb is to consider companies with a payout ratio under 50%. A company needs to retain some of its profits to reinvest in the business and to smooth out business cycles to ensure sufficient cash for future dividends.
- Review dividend growth.
A review of past dividend payments will indicate whether the company has consistently raised dividends in the past. Companies with consistent dividend growth tend to have consistent earnings accompanied by strong balance sheets and good cash flow.
* Source: Stocks, Bonds, Bills, and Inflation 2005 Yearbook. The S&P 500 is an unmanaged index generally considered representative of the U.S. stock market. Investors cannot invest directly in an index. Past performance is not a guarantee of future results.