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How to Invest in Dividend Stocks

NEW YORK (TheStreet) -- When you're evaluating a dividend-paying stock, the absolute primary thought has to be the viability and sustainability of the dividend itself. Find a company for which neither rain, nor sleet, nor dark of night will keep that courier from delivering a 3% payment to your account every year.

The clearest danger to a dividend is a lack of cash flow. When a company has weak cash flow, the dividend is among the first costs to be cut -- because this at least allows the company to appear to be bolstering that key metric. But a dividend stock that stops paying its dividend is of little value to anyone's portfolio.

How do you find a "safe" dividend? Look for companies whose operating earnings and cash flow can cover their annual payments at least two times over. It is possible, in the near term, to raise capital through debt or equity offerings to prop up dividends. However, most companies would not sustain this practice for more than a quarter or two.

It also helps to take a look at a company's dividend history. While it's never possible to predict the future from the past, some companies have exhibited a tendency to raise their payouts annually. It's also wise to seek out yields that are trending toward the higher end of historical ranges.

However, the analysis tools you need to employ on dividend stocks are not entirely earnings-centric. A lot of the same fundamental homework that goes into picking growth stocks will still apply here, but you need to add a layer of fixed-income-like analysis.

Dividend-focused investors are less interested in each individual trade and more concerned about whether a negative or positive earnings outlook would cause a firm to change its payout policy. The time frame is also longer than that of many retail investors, who generally consider a long-term position to be anything that's held for more than a couple of weeks. For any of the stocks in a dividend portfolio, the minimum holding period should be one year.

Of course, dividend or no, investors want to avoid any company whose stock might fall to $30 from $50. But if the same stock fell to $45 without a change in the fundamentals, that wouldn't be so worrisome in the near term -- because the losses would be cushioned by the dividend.

Facts About Dividends

Here's a quick lesson on basic dividend concepts, as well as some terms for new investors, or for those who would like a refresher.

First of all, dividends are generally paid on a quarterly basis and can be raised, cut or eliminated at each interval. Again, investors should be most interested in a firm that consistently and steadily raises its payout.

If someone says a stock has a 3% dividend, this is known as the yield. The yield is the ratio of the annual payment to the current share price (annual dividends per share divided by current price per share) -- so, given a constant rate of payment, the yield and stock price always move in opposite directions.

Another often-heard phrase, and an important factor in dividend investing, is the ex-dividend date. Investors need to buy a stock before this date in order to qualify for the dividend in any given period. Because buyers on the ex-dividend date will not receive the dividend income, if for example a company pays out $0.20 a share every quarter -- and all other things being equal -- the shares will likely open about $0.20 lower on the ex-dividend date.

The one wrinkle in all of this is that the dividend itself is usually not paid out until two to four weeks after the ex-dividend date. But investors can sell shares any time on or after the ex-dividend date and still receive the payout, even if the stock is no longer in their account. Of course, as I said earlier, dividend investors generally employ a longer holding period than a couple of weeks, but this remains a salient point to remember when you sell a dividend-paying stock.

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Dividend investors, find dividend stock ideas in our dividend investor center. Also, don't forget to bookmark our list of high-dividend stocks and ex-dividend date calendar.

David Peltier is a research associate at TheStreet. In keeping with company editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Peltier appreciates your feedback; click here to send him an email.

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