Before getting involved in dividend stock investing there are five major lessons you should learn.

1. Dividends are never guaranteed

There were many people who chose to ignore this particular lesson in the months and years that led up to the financial crisis. Collecting interest on investments like bonds and CDs is a given but that is not so with dividends. It is up to the board of directors to decide whether shareholders will receive cash dividends or not. It is in the best interests of the company for the board to attempt to maintain or even increase payouts because it is a sign that the company is financially sound. A company that is financially strong can, in turn, attract more investors.

2. Do not chase high yields

Greedy investors in recent years were taking higher risks to find acceptable yields. This was because market yields and interest rates were so low. This proved to be costly in the long run. Any dividend yield that is higher than 2.5 times the market average is something to avoid. With the current rate at two percent, you should avoid anything listed at five percent or higher.

3. Cash flow is king

Pay close attention to cash coming in and going out for at least the past five years. Focusing on earnings will not give you a true picture of whether a dividend will be sustainable or not. Make sure you account for capital expenditures and the amount that is left is the cash flow available to the company to buy back shares or pay dividends. This is called free cash flow. You also want to find out how much the company paid out in dividends annually. If the cash flow amount that is considered to be free is bigger that the dividends paid, then you can be assured that the company can maintain the current dividend.

4. Be selective

Be selective when you are choosing companies to invest in and keep your investments diversified. Cuts in dividends tend be widespread when the economy is in crisis. Do not rely solely on ETF’s or an index to protect you. You should know that the ETF is only permitted one rebalance each year. Many owners were left holding onto stocks that were suddenly not paying dividends at all or were paying out very low rates until the rebalance was allowed to occur.

5. It pays to diversify

It is still important to diversify. There is no doubt that the financial industry was hurt the worst over the last two years with deep dividend cuts. Even heavily diversified portfolios were hurt when the crisis hit but they were far less affected than those that were heavily weighted with financial stocks that were initially promising higher yields. Sector diversification is still very important even if you are forced to give up some yield at the outset.

With these five tips you will have no trouble building a portfolio of diverse companies that will yield above average dividends with enough free cash flow left over sustain continued growth.

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The word dividend comes from the Latin word ‘dividendum’ referring to anything that is divided up. This was applied to a number of participants dividing war booty or the rewards from trading. Now, similar to then one would want to raid the richest city or hopefully invest in stocks with high dividends.

The practice nowadays is that companies retain a portion of the profits, called the retained earnings and the remainder is divided amongst the shareholders according to the equity or amount of shares each shareholder owns. This dividend payout is done once a month, a year or a few times a year. If you get lucky you might even, in addition receive a bonus dividend.

Now, the question is what do you do with your share from said dividend investing? Well you can either keep the dividends as cash or reinvest in the same company using dividend reinvestment plans or DRIPS. This is a very good way to increase your share in the relevant company, thus increasing your share in a positively producing company holding stocks with high dividends. DRIPS investment portfolios run on automatic and are a great long term investment strategy as long as the company in question, on average performs positively and steadily. An added bonus is of course that you save on transaction fees usually incurred from the purchase of additional shares.

DRIPS dividend investing is a great way to invest if you are one of those people who do not like to watch the ups and downs of the markets with an eagle eye. Of course you should keep an eye on all your investment, but with DRIPS you do not have to do it as much.

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Normally when a company earns money out of its production, after retaining a certain amount, they would give out the rest of its earning to its shareholders as dividends. In short, after investing your money on a certain company, naturally if the business is good they should be able to earn a certain amount. This amount is what you give back to your investors.

A dividend yield indicates how much one gets for a certain stock. It is computed as dividends that are given out annually, divided by the price per share. As an investor, they usually look at these data to see which stocks or companies are worth investing in.

Thus, if two companies give out the same dividends, it doesn’t automatically mean that they would have the same dividend yields because it would greatly depend on a price per share. And so let us look at the following example:

Company A  Dividends: $10
Price Per Share: $20

Dividend Yield: 50%

Company B  Dividends: $10
Price Per Share: $40
Dividend Yield: 25%

Based on this, one could assume that just because a stock has a higher price per share does not necessarily mean that it has higher Dividend Yield. And for sure they would prefer the stocks of Company B.

Some investors would prefer stocks with higher dividend yields as it means they could get more money for what they have invested in. However, some would say that having high divident yields could indicate an underpriced share and may mean that the company would not earn soon. It’s still an ongoing discussion about the importance and accuracy of dividends yields. Well, there is always two sides to a coin.

In relation to this, there is also the Ex-Dividend which is important to understand. Once the Ex-Dividend Date is declared, whoever owns the stock during that time will receive the dividends declared, however after receiving such dividends, anyone who buys these stocks will no longer benefit from receiving dividends. Naturally the price for these stocks would also decrease as there would be lesser demand for them.

Related posts:

1. Blue chip dividend stock and Dogs of the Dow theory
2. Dividend Stock Investing – Lessons learnt in recent past
3. Dividend investing for stocks with high dividends choose DRIPs