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How to invest in dividend stocks

Dividend stocks can be a great way to generate a reliable income. But when used correctly, they can also deliver big capital gains and highlight potential bargain buys.

Most of my portfolio is invested in dividend stocks. Today I’m going to explain how you can get started with income investing – and why I think it’s a great idea.

What’s a dividend?

A dividend is a cash payment that’s made to a company’s shareholders, usually twice a year. It’s paid out of a company’s after-tax profits.

The payout may be a fixed percentage of profits each year, or it may be calculated based on what the board thinks is affordable. Some companies target a progressive dividend, which means they aim to increase the payout every year.

Why buy dividend stocks?

Fast-growing companies tend to pay smaller dividends – or none at all – as they need to reinvest their profits in growth projects. My focus is mostly on companies in the FTSE 250 and FTSE 100. These are usually large enough to support steady growth, while still generating spare cash for dividends.

Owning dividend stocks gives you two great choices. When dividends are paid into your share account, you can withdraw them to provide a cash income, or you can use this cash to buy more shares.

Taking an income will mean that the value of your stock portfolio will only rise when the value of your shares rises.

But by using your dividend cash to buy more stocks, you can enjoy much bigger gains thanks to the wonder of compounding. For example, a 5% yield reinvested in the same stock each year would double your money in 14 years, even if the share price stayed flat.

In addition to the compound growth from your reinvested dividends, you’d also get the benefit of any share price growth.

What could go wrong?

The main risk I worry about is that the companies I own might have to cut their dividends.

The simplest way to judge the safety of a dividend is to compare it with earnings per share. If earnings cover is high – perhaps 1.8 times or more, then the payout is probably safe. But if earnings cover is very low, then the risk of a cut could be higher, especially if profits are falling.

To be safer still, it also pays to check whether dividends are covered by a company’s free cash flow. This is the surplus cash left over after all costs and capital expenditure have been paid each year.

A dividend that’s covered comfortably by free cash flow is generally pretty safe, in my experience.

Spotting bargain stocks

Some companies have high dividend yields because they are mature, slow-growing businesses. In these cases, a high dividend yield usually suggests the shares are at fair value.

However, some stocks offer high yields because they are suffering temporary difficulties and are out of favour. A share price recovery could be just around the corner.

Spotting these bargains isn’t easy, but can be very profitable. My tip would be to look at the company’s past profits and ask whether it can return to that level of profitability in the future. If the answer is yes, then the shares could be a bargain.

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Roland Head has no position in any of the shares mentioned. 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.