When you think of investing for income, your first thought may be of bonds. Certain types of equities, however, also provide income and may offer a suitable alternative for some investors. While most bonds offer fixed income (payments that stay the same throughout the term of the bond), the dividends paid on high-yielding stocks may increase or decrease over time.
Capital Growth or Income
When deciding whether to include income stocks in the equity portion of your portfolio, it’s important to consider whether your primary goal is capital appreciation or income.
The capital appreciation potential of high-yielding stocks generally lags that of growth stocks, while the income potential is usually greater. With high-yielding stocks, capital appreciation isn’t the primary contributor to total return. This is because the majority of a high-yielding company’s earnings are paid out in the form of dividends, rather than invested back into the company for internal growth.
Therefore, earnings and company profitability are very important factors in choosing income stocks. Generally, higher earnings and cash flow result in higher dividends. In addition, if earnings growth exceeds the inflation rate by two or more percentage points on a yearly basis, the income from future dividends has the potential to be quite satisfactory. In other words, on a total return basis, an investment in high-yielding stock may be very attractive.
Types of Income Stocks
The following types of stocks may be worth considering if you’re seeking income:
- Regulated utilities. State boards determine the rates gas and electric utilities may charge their customers. Because of these regulations, purely regulated utilities-or those with a very small amount of non-regulated business-have little flexibility and little opportunity for earnings growth. Therefore, the value of the stock lies in its yield, which is usually higher than that of most non-utility stocks.
- Closed-end exchange-traded bond funds. Closed-end exchange-traded funds are regulated investment companies that provide many of the same important advantages as mutual funds, such as diversification and professional management. However, the common shares of these funds trade like stocks on an exchange-at a price that may be higher or lower than the market value of the fund’s assets per share (the net asset value).
Evaluating Income Stocks
In selecting a high-yield stock, the company’s financial strength is a key factor. Income-oriented investors seek stability and predictability in the dividend. An excellent way to gauge financial strength is to ask your financial advisor for the company’s Standard & Poor’s (S&P) rating. It’s generally not advisable to choose a high-yielding stock with a rating below B+.
The dividend payout ratio, which measures the percentage of earnings paid out to common shareholders in dividends, is another factor to consider. The dividend payout ratio is found by dividing the company’s annual dividends by its earnings per share. As a hypothetical example, assume XYZ corporation pays a $1 annual dividend and has earnings of $3.08 per share. The dividend payout ratio in this case would be 32.5 percent ($1 annual dividend divided by $3.08 earnings per share). Generally, a low payout ratio means the dividend may have the potential to be increased.
With a relatively high payout ratio, there’s the possibility deterioration in earnings could cause the company to lower its dividend. One exception has been regulated utilities, which generally have had high payout ratios but dependable earnings and dividends. IBI