The Case for Holding to High-Flying Dividend Stocks
Now let me use the example of a high-flying stock like the ones Carol may have in her portfolio to show you how hanging on may be the smartest thing you can do.
Let’s say you bought McDonald’s (NYSE:MCD) at $18 a share in 2002. It was paying dividends of 23.5 annually for a yield of 1.3%. Now the stock is up 280% in your portfolio! You may want to take profits, right?
Wrong. Because as a dividend investor you may never find a bigger payday than MCD at your cost basis. You see, McDonald’s is now paying 70 cents a quarter in dividends for $2.80 annually! That’s a mammoth 15.5% yield on your cost basis.
Do you think you can get a better income generator on Wall Street than that?
Even if McDonald’s stock declines 30%, as long as the dividends remain constant you are getting a huge payday. So if your primary goal is to generate big dividends, then selling your 15.5% cash cow would be a giant mistake.
Dividend Payout Ratio
How can you ensure that those dividends you’re receiving are sustainable, though? Well just look at the dividend payout. It’s a simple calculation of taking the annual dividends divided by the earnings per share.
Let’s take dividend stalwart Procter & Gamble (NYSE:PG) is paying 56 cents per quarter or $2.24 per share annually. It is estimated that PG will earn $3.90 in earnings per share for the current fiscal year. Thus, it is paying 57% of profits back to shareholders in the form of dividends.
Historically, 50% is about right for major corporations. Obviously, if you’re pushing 80% or 90% of profits as dividend payments, you run the risk of a dividend cut if earnings take a tumble. A little cushion is necessary for sustainable payments.
Also, a lower rate of around 30% or less may signal the potential for bigger dividend increases going forward. Even if profits flatline, the company can comfortably increase payments.
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Jeff Reeves is the editor of InvestorPlace.com and the author of “The Frugal Investor’s Guide to Finding Great Stocks.” Write him at firstname.lastname@example.org or follow him on Twitter via @JeffReevesIP. As of this writing, he did not own a position in any of the stocks named here.