3 ways to become a better dividend investor

Following these tips will pay off in the long run.

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This article was originally published on Fool.com. All figures quoted in US dollars unless otherwise stated.

Investors who prioritize dividends and intentionally build a portfolio of dividend-paying stocks typically see massive rewards in the long run, often receiving thousands in monthly retirement income. Profiting from some stocks relies solely on increases in their stock price, but dividends essentially reward investors for holding onto shares. If you want to become a better dividend investor, here are three things you should do. 

1. Focus on companies that increase dividends

What largely makes you successful as an investor is seeing the potential in companies and capitalizing accordingly. You should make decisions primarily with the future in mind, not focusing solely on the past or current metrics. A company's current dividend yield is important, but what dividend investors should strongly consider is its ability to increase its yearly dividend. Companies may pay the same dividend, but if one is increasing its dividend by 10% annually, it's more attractive.

Certain companies that have increased their annual dividend payouts for at least 25 consecutive years become part of S&P Dow Indices' Dividend Aristocrats list, while companies that have increased their payouts for at least 50 consecutive years are Dividend Kings. As a dividend investor, if you focus on either, you can be more confident in your investment. Any company that has managed to become a Dividend Aristocrat or King has shown it can withstand broader economic down periods and recessions and still have the proper cash flow to reward shareholders.

History shows that market down periods are inevitable; you might as well invest in companies that have the financial means to make it through such times.

2. Focus on dividend payouts, not yield

It's common for investors to look at a company's dividend yield before making investment decisions, but that can sometimes be misleading. Think about this: Dividend yield is based on the annual dividend payout relative to the company's stock price. If a company pays out $5 annually in dividends and the stock price is $100, the yield is 5% -- which is very lucrative on the surface level.

However, if the stock price drops to $50 for whatever reason, the dividend yield becomes 10%. By all means, a 10% dividend payout is seen as good, but when you consider the sharp price drop that led to that yield, you understand why that alone isn't a good metric. It would be best if you considered what caused that sharp price drop.

Instead of a strict focus on dividend yield, examine a company's dividend payout to get more insight into its financial health. The payout ratio is how much of a company's earnings it's paying out in dividends. A payout ratio above 100% -- meaning the company is paying out more than it's making -- is a major red flag because it's unsustainable in the long run. It helps to be skeptical of companies that have a dividend payout of more than 50%.

3. Watch out for dividend traps

Dividend traps often occur when something is too good to be true. Let's take younger, smaller companies, for example. Dividends are paid from a company's earnings, so any money paid out in dividends is money that's not being reinvested back into the company. For smaller companies, growth is often high on the priority list, and if management is giving too much of its profit to shareholders instead of reinvesting it back into the company, that could be a cause for concern.

There are some exceptions -- like real estate investment trusts (REITs) and master limited partnerships (MLPs) -- which have high dividend yields built into their structure. But generally speaking, if the dividend yield seems to be questionably high, you likely want to take a deeper look at why.

The same goes for debt. A company's debt-to-equity ratio -- found by dividing its total debt by shareholder equity -- lets you know how much of its daily operations are financed through debt. As a rule of thumb, the higher the debt-to-equity ratio, the more risk a company is taking. You want to be cautious of companies with a lot of debt that pay out dividends. Financially healthy companies should be able to pay out dividends from their profits. 

This article was originally published on Fool.com. All figures quoted in US dollars unless otherwise stated.

The Motley Fool Australia's parent company Motley Fool Holdings Inc. has no position in any of the stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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