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Are you making these mistakes when buying dividend stocks?

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With cash savings rates at all-time lows, many investors are turning to dividend stocks to boost investment returns. While dividend investing sounds simple, in reality it’s more complicated than just buying the highest yielding stocks, and many investors make critical mistakes when searching for dividend investments.

Play the game right and dividend investing can be a very profitable strategy over the long term, but invest in the wrong dividend stocks and your portfolio is likely to suffer. Here are a few key issues that investors should be aware of when investing for dividends.

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Beware a high yield

There’s a lot more to successful dividend investing than simply buying high yielding stocks and the key mistake that many investors make is reaching for that high yield as a priority. Simply buying the highest yielding stocks in the FTSE 100 is unlikely to be the best investment strategy.

Why? The old adage that ‘if it seems too good to be true it probably is is highly relevant here. More often than not, if a yield is unusually high, it means the market believes a dividend cut is forthcoming, a signal to tread carefully. Dividend cuts can be lethal for your portfolio as the chances are you’ll suffer both a capital loss and a reduced dividend. So it’s extremely important that you reduce the chances of a dividend cut by treating a suspiciously high yield with caution.

Focus on dividend growth

Another key dividend concept is to ensure that you not only focus on the dividend yield, but also on the dividend growth.

While dividends will contribute significantly to your overall returns over time, growing dividends can really put a rocket under your long-term returns. It’s one thing to find a company that consistently pays a 5% dividend per year.But if you can find a company paying a 4% dividend with 10% dividend growth per year, within 10 years the company could be paying you a dividend of over 10% per year. OK, that may not happen often but it does illustrate my point. Furthermore, when a company raises its dividend, demand for the stock generally increases, so it’s likely you’ll see both an increase in the share price too.

Pay attention to the financials

An obvious point: it’s wise to monitor the financial health of a company when looking for dividends. Revenue growth is a good place to start as without that a company will be hard pressed to grow its dividend in the future. It’s also useful to monitor free cash flow as this tells investors how much cash a company has left over from its operations to pay for dividends.

Keep an eye on the dividend coverage ratio, which divides the company’s earnings per share by the dividends per share. A ratio of less than 1.5 indicates danger of a dividend cut, while a ratio of 2.0 is seen as more healthy. The dividend-to-free cash flow ratio is another useful indicator, the lower the ratio the better.

Research the dividend policy

Lastly, it’s worth researching the company’s dividend policy. Does the company pay out a stable dividend each year or are a certain percentage of earnings paid out as dividends? This information should be available on the company’s website and will help you make an informed decision when looking for dividend stocks.

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