Investing in dividend-paying stocks is one of the safest strategies for playing the stock market over the long term. A dividend is a payment by a company to its shareholders. Not every publicly traded company pays dividends; those that do must have ample liquid cash available to make the regular payments.
Dividend yields represent the ratio of the annual per share dividend to the company's per share price. A high-yield dividend stock is one that pays more than about 3.5 percent in periods of low interest rates, or above about 5 percent during other periods. It's not uncommon, however, for some stock dividend yields to be well above 10 percent. Because the per share price varies, companies describe their dividends in terms of dollars per share distributed annually.
Most high yield dividends come from old, well-established companies who are no longer growing quickly, but still generate large sums of cash each quarter. Real estate investment trusts (REITS), and similar resource-based trusts, are investment funds that get special tax treatment as long as they distribute all their quarterly profits as dividends. These kinds of vehicles, which trade as stocks, represent a major segment of the high yield dividend market.
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Dividends are valuable to investors because they represent fairly reliable fixed return on their investment. When the share price of stock holdings increase, the dividends represent additional value. If the share price declines, dividends are like a partial reimbursement, limiting the losses.
Not all dividends are created equal, however. A company with a high yield might become unable or unwilling to continue dispensing with so much cash each quarter. As mentioned, the yield is calculated based on the per share price--if the share price falls precipitously, the yield will rise, but not necessarily represent a good value for investors. Companies can reduce or eliminate their dividends without notice. It takes research to discern the viability of a company's stated dividend.
To evaluate a company's dividend potential, analysts compare the total cost to the company of paying the dividend (dollars per share times outstanding shares) with the free cash flow reported on the company's financial statements. A company with growing cash reserves will be able to increase their dividend, a very attractive proposition for investors.