Many stock and stock-fund investors, especially retirees and others who are focused more on income than capital appreciation, choose stocks or funds based on their dividend yields. The problem, though, is that a stock’s yield in itself tells you nothing about a company’s health or prospects for the future—and in fact, an attractively high dividend yield can be a very bad sign.
First, you need to understand what the dividend yield represents. The dividend itself is a fixed amount of money—set by the company’s board of directors—that is paid to shareholders for each share of stock they hold. To get the yield, you divide the annual dividend by the share price and get a percent.
In many cases, a high dividend yield reflects a falling stock price. As long as the actual dividend amount remains constant, the more that a stock price falls, the higher the yield rises.
For a more effective portfolio, investors should put greater focus on dividend growth rather than yield. Companies that repeatedly raise their dividends, especially those that boost them by 5% to 10% a year, typically are showing that they are optimistic about their futures. And dividend growth can help offset the impact that inflation can have on the value of your investment returns.
In recent years, the rate of inflation has been modest, but it still plays a role, and inflation may ratchet up in coming months and years. That’s a particular concern for retirees living off their investment portfolios. For people on a fixed income, concentrating on yield growth helps ensure that dividends don’t become a weaker and weaker component of the portfolio’s overall returns.
Even better, when dividends grow briskly, you don’t need to sell as much stock each year to generate your desired retirement income—which means that you are not so much at the mercy of market fluctuations.
You can review a stock’s dividend yield easily enough on any mainstream finance website, but dividend growth is a little harder to find. The site GuruFocus does a pretty good job tracking dividend growth metrics. Yahoo Finance doesn’t give a stock’s dividend growth rate, but it does cover dividends in its historical data section, so you can use that to calculate dividend growth.
When comparing the dividend growth of different stocks, you’re not looking for a stock that has raised its dividend only in the current or previous year—you want to see steady dividend growth. Apple and Microsoft are two good examples of healthy companies that raise their dividends religiously. But you don’t have to buy individual shares to participate in this strategy because there also are mutual funds and exchange-traded funds that follow a dividend-growth strategy, such as the Vanguard Dividend Appreciation Index Fund (VDAIX) and the ETF version of the fund (VIG). Every holding in these funds has raised its dividend for at least 10 years running.