There's a reason so many investors love dividend stocks: They can be a solid source of passive income. Plus, if you don't need your dividend payments to cover expenses, you can reinvest them for added growth in your portfolio.
But while there's nothing wrong with building an investing strategy that focuses on dividend stocks, you should also be careful when buying them. In fact, there's one specific question it always pays to consider when a dividend stock hits your radar.
Is this a strong business?
Some dividend-focused investors get so caught up in chasing high dividend yields that they make the mistake of overlooking one important factor: how well the company itself is doing. Contrary to what you may have been led to believe, a higher dividend is not necessarily indicative of a company's financial strength.
Let's take a second and think about what dividends are: They're a portion of a company's profits that's being shared with stockholders instead of being reinvested in the business. But just because companies choose to share the wealth doesn't mean they have a lot of wealth to share.
Think about it this way — you might be someone who's barely able to cover your rent and credit card payments at the end of the month, but you might still choose to give your friends generous birthday gifts because you want to make them happy. Companies that pay dividends often take a similar approach — they continue to pay stockholders to keep them satisfied, even if money isn't exactly free-flowing.
That's why it's so important to really dig into a company's financials before chasing the dividend it's paying. If the company is managing its cash well, has a reasonable amount of debt, and has a number of viable revenue streams, then sure, go ahead and scoop up shares that will result in generous dividends.
But you shouldn't buy shares of a company simply because its dividend is high. If you go that route, you could end up losing money if the value of your shares declines over time.
Along these lines, do realize that when companies are generous with shareholders, they forgo the chance to pump money back into things like research, marketing, and operations. And that could stunt their growth. So all told, if you chase stocks with higher-than-average dividend yields, you could end up with lower-than-average share price appreciation through the years.
Be careful with dividend stocks
Buying dividend stocks is a great way to set yourself up with passive income. And many companies that pay dividends are also solid businesses with strong prospects.
The point, however, is to not base your decision to buy a stock off of a dividend yield alone. Instead, think about the business behind that dividend when making your choice.
And also, remember that companies that pay dividends aren't required to do so. So just because you may be looking at a large dividend today doesn't mean that will be the case three, five, or 10 years from now. That's all the more reason to focus on the big picture.
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