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The 2 dividend rules I live by when investing in stocks

What exactly are dividends? They are, of course, profits earned by a company and distributed to shareholders. This is important to remember, because just as with small businesses, how much profit to take out of a firm or how much to keep in for reinvestment can make or break a company. Dividends are no different, which is why I always look at the two rules I think of as 5 by 5.

5 by 5

A cheesy name perhaps, but it fits. Simply put, my first rule is to look for a dividend yield in the 5% range, while my second rule is to look for consistent five-year dividend growth.

Assuming the dividend is a factor in your investment choice, it has been my experience that a yield in the 5% area (actually about the 4% to 6% range) is a perfect balance – a goldilocks zone so to speak. Yields above this, though appealing for obvious reasons, usually bring up two major concerns for me.

The first is whether or not the company can actually afford it. If some of the most stable, long-running and profitable blue-chip companies in the world only offer yields of 4% to 5%, what are the chances that other companies can, or should, offer more than this in the long run?

The second problem, and the one that concerns me even more, is that a higher yield is almost always an attempt to entice investors, which means there are probably more negative things worth worrying about on the company’s books.

There are always exceptions of course, and as the dividend yield is derived from a share price it is often open to short term fluctuations that may have nothing to do with underlying fundamentals, but rather speculation.

BT is a prime example of this. At its current price, it has a dividend yield of more than 9% — far above my normal criteria. However I think this is more a development of BT shares being oversold at the moment, rather than management distributing too much money. The dividend itself is actually in line with last year’s number.

Pennies not percentages

My second rule – looking for consistent five-year dividend growth – is somewhat self-explanatory. Not only do I want a nice dividend yield, but I want those dividends to be growing year-in and year-out. Though yield is always my major concern, dividends are not paid as a percentage of the share price but rather in pennies or cents per share.

We use yield as an easy comparison to other investments, but underlying this we want those actual pennies per share to be growing each year. A five-year timeframe is usually good enough for a fair evaluation.

One stock that matches both my criteria at the moment is BAE Systems. With its share price having done well in recent weeks, its dividend yield now comes in just over 4%, at the lower end of my range, but solid given the company’s fundamentals. Meanwhile these dividends have shown consistent growth of more than 2% year-on-year for the past five years. Exactly what I look for.

When investing in stocks then, always try to keep in mind my two 5 by 5 rules.

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Karl has shares in BT Group and BAE Systems. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.