With interest rates at historic lows, investors are searching beyond the fixed-income markets for reliable yield. Bonds, which have been traditionally viewed as the safe haven for income investors, may now pose more risk than reward.
“Not only do bonds offer paltry interest rates, but at today’s historically low rates, they subject capital to significant risk, should interest rates rise in the future,” says Rick Myers, founder and president of Integrated Financial Services. Interest rate risk, common to all bonds, is when a future rise in interest rates causes bond prices to fall.
Given the current state of bonds, dividend-paying companies look increasingly appealing for income. “The dividends of many companies are significantly higher than bonds, while additionally offering upside share price appreciation potential,” Myers says. They are also not subject to interest rate risk, should rates rise.
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In addition to income, ” dividend-paying stocks tend to be more predictable over time and generally more defensive in volatile markets,” says Chris O’Keefe, managing director at Logan Capital Management.
Not just any dividend-paying company will do. To pick the best dividend payers for your portfolio, you need to understand the difference between the dividend rate and dividend yield, and how to use each to evaluate a dividend-paying investment. Here are a few points of guidance:
— The difference between the dividend rate and dividend yield.
— A closer look at dividend rates.
— A closer look at dividend yields.
— Using dividend rate and dividend yield.
The Difference Between the Dividend Rate and Dividend Yield
“Dividend rate is the absolute amount of dividends being paid quarterly or yearly, while dividend yield measures the dividend paid as a percentage of the equity,” O’Keefe explains. “Dividend yield gives investors an idea of how much income they can expect to receive relative to their equity investment on a periodic basis.”
It’s important to distinguish between the dividend rate and dividend yield when evaluating an investment because they reveal two entirely different things.
“The dividend rate tells you how much money you will be paid in a fiscal year, per share, from owning the stock,” Myers says. “The dividend yield tells you the rate of return you will receive that is generated from dividends at the current market price of the stock.”
While the dividend yield is the more commonly cited measure, both are useful for dividend investors to understand.
A Closer Look at Dividend Rates
The dividend rate reveals how much income you can expect an investment to pay. It’s expressed as the dollar value of the dividends paid by a company.
Although U.S. corporations usually pay dividends on a quarterly basis, the dividend rate is most often expressed on an annual basis. If Company X pays a $1 per share quarterly dividend, its annualized dividend rate is $4 per share per year.
[SEE: Top 10 Dow Dividend Stocks to Buy Now.]
“A dividend rate is important, as it tells a shareholder how many dollars they can expect to receive based on the number of shares they own,” Myers says. “If you multiply the dividend by the number of shares you hold, that will give you the dollar amount that you can expect to receive.”
For example, if you own 100 shares of Company X, you can expect to get $400 in dividends per year.
A Closer Look at Dividend Yields
The dividend yield takes the annualized dividend rate and expresses it as a percentage relative to a stock or fund’s share price.
It’s calculated as the annual dividends per share divided by the stock price. If Company X is trading at $10 per share, it has a 40% dividend yield.
Dividend yield allows investors to compare the dividends of two or more stocks on a percentage basis, Myers says. If Company Y also pays a $4 annual dividend but trades at $100 per share, its dividend yield is 4% compared to Company X’s 40% dividend yield.
Using Dividend Rate and Dividend Yield
“Both the dividend rate and dividend yield are important when evaluating investments,” says Matt Egenes, managing director and client portfolio manager at Barrow, Hanley, Mewhinney & Strauss. Investors should look for companies with sustainable or growing dividends.
“A company or fund that increases its dividend rate will also increase its dividend yield, all else equal,” he says. However, because dividend yield depends on price as well as dividend rate, an investment’s dividend yield can also increase when its share price decreases.
“An investor would want to see the dividend rate increasing, and thus the dividend yield increase, for the right reason rather than because of a price decline,” Egenes says.
[See: Best Buffett Stocks to Buy for Dividends]
Dividend growth is a better indicator of relative performance over market cycles than absolute dividend yield, O’Keefe says. “A growing dividend signals to investors that the company has a bright outlook regarding its future cash flows and balance sheet strength.”
However, be wary of companies with dividend yields that may be too good to be true. “Stocks with very high dividend yields may be signaling a future dividend cut,” O’Keefe says. This is why it pays to be a savvy dividend investor.
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Dividend Rate vs. Dividend Yield: The Difference Investors Should Know originally appeared on usnews.com
