The market is down and inflation is up – so what’s out there for an investor looking for growth, appreciation and stability? You can try dividend-paying stocks. Many companies that pay dividends are still profitable during a market downturn so investors will still receive dividends. That cash infusion can help offset some of the losses you might be seeing in the market that you can redispose at your pleasure. If you’re not sure how to approach these investments, consider working with a financial advisor.
Why Dividend-Paying Stocks Can Work During Inflation
Stocks of companies that pay good, steady dividends really come into their own when the market heads down. These companies typically are well-established operations that are well-positioned to ride out the ups and downs of the economy while generating enough profit to pay cash to shareholders. These dividends can provide cash to investors, which helps offset the damage of inflation, or the dividends can be reinvested in new shares, increasing your holdings and returning additional growth when the share price gains.
To get a picture of how dividends work, compare the total return on two stocks with the same price appreciation in a given period, where only one pays a dividend:
Opening share price: $10
Closing share price: $12
Net gain: $2+$0 = $2 (20%)
Opening share price: $10
Closing share price: $12
Net gain: $2+$1 = $3 (33%)
Importance of Stock Dividends
How important are stock dividends? According to an analysis of stocks in the Standard and Poor’s 500 Index by Fidelity, the added value of dividends was the factor that allowed stocks to beat inflation during the 1960s and 1980s. During the poor-performing decade of the 2000s, dividends accounted for all of the gains stocks made. Overall, the Fidelity analysis found, “Dividends have accounted for 40% of stock market returns since 1930 and 54% during decades when inflation has been high.”
Since 2010, share price appreciation has accounted for most of the gain in stocks, and with inflation and interest rates low, returns on growth stocks of rapidly expanding firms – especially tech stocks – easily outpaced inflation. High inflation and rising interest rates make it difficult for companies to borrow to finance growth, causing those share prices to weaken.
By contrast, the positive cash flow of dividend stocks allows them to continue paying dividends, stabilizing their share price and providing income or growth to investors. Rising inflation also can allow many well-established dividend-paying companies, such as those in the consumer staples sector, to raise prices, allowing them to increase dividends.
How to Value Dividend-Paying Stocks
In valuing dividend-paying stocks, investors can start by focusing on two key ratios: dividend yield and payout ratio.
- The dividend yield is the current share price divided by the value of the stock’s annual dividend, which means a stock trading at $125 and paying an annual dividend of $3 (75 cents per quarter) would produce a dividend yield of 2.4%. However, a high dividend yield isn’t necessarily a sign that a stock is a good buy. If a company is struggling and doesn’t cut its dividend, the dividend yield will rise as the share price drops.
- The payout ratio is the amount of net income that goes into paying shareholder dividends (both numbers can be found in the company’s) quarterly and annual reports. A low payout ratio suggests the dividend is likely to be sustained or even increased.
In both cases, investors should look at the dividend yield and payout ratios over time to gauge the stock’s potential return, along with the trend in the dividend amount. Companies that have consistently maintained or even raised their dividends over time are considered the most reliable.
What Are Dividend Aristocrats?
Stocks listed on the S&P500 where the base dividend has been paid and raised for 25 straight years are classified as “Dividend Aristocrats.” The 65 current Dividend Aristocrats feature a number of household names, including Coca-Cola (NYSE:KO), Johnson & Johnson (NYSE:JNJ) and Colgate-Palmolive (NYSE:CL).
How to Buy Dividend-Paying Stocks
One easy way to get involved with dividend-paying stocks is to purchase shares from companies that offer direct stock purchase plans, “DSPPs,” combined with automatic dividend reinvestment plans, or “DRIPs.” Once you set up an account and purchase shares, dividends are automatically reinvested in new shares. Companies offering these plans include Walmart, Starbucks and Coca-Cola.
The Bottom Line
When a company pays dividends it is distributing cash profits to its shareholders. This type of investment is strong when the market is down because the cash received in the dividend offsets some losses in the market. You can value a dividend-paying stock either through the dividend yield or through the payout ratio to see if it might be a good opportunity for your portfolio right now.
Tips for Investing
- Investing can help you achieve long-term wealth or help you hit retirement at a reasonable age. It can be difficult to find the right asset allocation for your long-term goals on your own. Many decide to use a financial advisor who has the right amount of experience in the market to potentially help manage your assets. Finding a financial advisor doesn’t have to be difficult. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Consider using SmartAsset’s asset allocation calculator to find the right balance in your portfolio, especially if you’re attempting to invest on your own.
Photo credit: ©iStock.com/damircudic, ©iStock.com/tdub303, ©iStock.com/FG Trade