Dividends are a form of profit from a company’s earnings that get distributed to the shareholder as a cash payout.

During the glory days, receiving a 1–2% dividend was not as important when you could capture the growth stocks high returns.  An example in today’s market is “Apple”; they are a double digit growth stock paying nothing out in dividends to shareholders.  But, the glory days of most double digit returns in the stock market are being replaced with dividend paying stocks.   Today, more companies are paying dividends due to lower returns and investors’ demand of getting paid something for taking the risk.   Also, today, investors are purchasing dividend paying stocks yielding 3%, 4%, 5% making them competitive to bonds on a yield basis alone.    Add some capital appreciation potential to the mix and you may outperform even junk bonds (which yield 6-7% or higher) on total return basis.

It is easy to see the appeal of dividend paying stocks but we must keep in mind that the company paying these dividend yields must be able to sustain them.   A couple of good fundamentals to review are Free Cash Flow Yields, history of dividend growth and long term growth of the company.

Free Cash Flow Yield is the amount of cash left over after all expenses are paid for.  This yield should be greater than the dividend yield and show consistent growth year over year.  Many factors go into the underlying number of free cash flow that will need to be considered and one of them is acquisitions.  If a company acquires another company then cash flow will be impacted.  This is one reason the cash flow may fluctuate and that is okay as acquisitions, most commonly are healthy for a company’s long term future.  An example is Pepsi.  Pepsi pays a 3.22% dividend yield and their free cash flow yield is 5.58%.  Pepsi passes this screening.

Dividend growth history will show how sustainable the current dividend is.  A dividend doesn’t have to grow every year but over time it is nice to see the company increasing the shareholders profit as a sign they are continuing to grow their company.   Staying with Pepsi, they have increased their dividend by 6.61% over three years and 11.41% over five years. Pepsi passes this screening as well.  A reduced or eliminated dividend is a sign the company is struggling to make profit.  This may not be a safe investment.

Tax treatment favors dividend paying stocks through 2012.  Qualified stock dividends are taxed less than ordinary income where bond income, by contrast, is taxed at ordinary income tax rates.

A well diversified portfolio that compliments your overall objective is the strategy one should have.

Good luck and know what you are invested in.