Dividends aren’t really the stuff of news headlines. Compared to the growth stocks of buzzy tech upstarts, dividends can feel old-school. But consider this: over the past 10 years, dividends have quietly delivered nearly 40% of the S&P 500’s total return. In other words, close to half of the market’s long-term wealth came from the cash companies paid to their shareholders, not the price of their stock rising higher.
But many investors skip dividend-paying stocks. Why? Because they think what matters more is a company with stock whose price keeps going up.
That can be a mistake. Dividends aren’t just a fun little bonus. They can be a key part of building long-term wealth and can help provide a bit of cushioning in your portfolio when the market gets rocky. This is where the concept of total return investing comes in. Instead of focusing on dividends or price growth alone, total return investing looks at the full picture: the gains you get from rising stock prices, the dividend income you receive along the way, and how reinvesting those dividends can compound your returns over time.
Understanding how dividends work — how they get paid out, how they grow, the potential pitfalls, etc. — and how they contribute to a total return investment strategy can help you build a stronger portfolio.
What are dividends?
First, a refresher on what exactly dividends are:
Dividends are payments that a company distributes to its shareholders. When a company earns more than it needs to operate and fuel its growth, it can choose to pay its shareholders a portion of those profits.
Choose is a key word; some companies don’t offer dividend-paying stocks, instead reinvesting all profits back into the business. That’s not a bad thing. Consistent, year-over-year dividends are, however, usually a pretty good indicator that a company is strong and stable, with a reliable cash flow.
The perks of dividends go beyond income. Many long-standing companies raise their dividends over time, and above inflation rates, which helps you keep up with rising costs. Dividends can also help you stay invested. Seeing regular payments makes it easier to resist the urge to watch price swings and jump in and out of the market.
How do dividends perform in different market cycles?
Depending on the market cycle, dividend-paying stocks often perform differently than non-dividend-paying stocks.
In a bear market. During periods of falling stock prices and negative investor sentiment, dividend stocks usually hold up better. Because part of their return comes from company income, not just market price movements, dividend payments may remain steady (though they can be abruptly cut in extreme circumstances) and help soften the impact of falling prices. Contrast that with growth stocks: in bear markets, investors are more cautious and less willing to bet big on future potential. Because growth stock returns depend entirely on price movements, there’s nothing to cushion their decline when prices drop.
In a period of volatility. Even if share prices fluctuate wildly, dividends that continue to be paid provide a steady stream of cash that can be reinvested at lower prices, which can boost the effects of long-term compounding.
In recovery. As markets recover, many companies increase their dividend payments, helping investor returns recover, too. And because dividend-paying companies are usually more mature and stable, their rebound is often quicker and more consistent than an upstart.
How to tell if a dividend is sustainable
If you’re considering investing in a dividend-paying stock, you need to evaluate whether that dividend is reliable.
Investors use two different metrics to gauge a dividend: payout ratio and dividend coverage ratio.
Payout ratio tells you what percentage of a company’s earnings is being paid out as dividends.
Dividend coverage ratio tells you how many times the company’s earnings cover the dividend.
How to calculate payout ratio
There are two common ways to calculate payout ratio:
Dividends per share ÷ earnings per share
Total dividends ÷ net income
Here’s an example of each formula in practice:
Let’s say a company earns $1 per share and pays a $0.40 dividend. The payout ratio is 40%, which means the company is keeping 60% of its profits to reinvest in the business and paying the remaining 40% to its shareholders.
The company has 100 million shares outstanding (meaning 100 million shares that are currently owned by shareholders). Total dividends equal $40 million ($0.40 per share × 100 million shares). Net income equals $100 million ($1.00 per share × 100 million shares). Divide $40 million by $100 million, and you get the same payout ratio of 40%.
A higher payout ratio isn’t necessarily better than a lower payout ratio, or vice versa. It depends on the company itself and the industry it belongs to.
How to calculate dividend coverage ratio
Dividend coverage ratio is calculated using the same inputs as payout ratio, but in reverse order:
Earnings per share ÷ dividends per share
Net income ÷ total dividends
Using the same example as payout ratio:
Let’s say a company earns $1.00 per share and pays a $0.40 dividend. Earnings per share divided by dividends per share results in a coverage ratio of 2.5.
If the company has 100 million shares outstanding, total dividends equalling $40 million, and net income equalling $100 million, net income divided by total dividends equals the same coverage ratio of 2.5.
A coverage ratio of 2.5 means the company earns two and a half times what it needs to pay its dividend. Generally speaking, a ratio of 1.5x or higher is a sign of safety (although this can vary by industry and business model); higher coverage ratios usually indicate the company has more flexibility and cushioning if earnings fall. That said, a higher or lower number isn’t automatically a good or bad thing. Like payout ratio, it can depend on the company and the sector it operates within.
Payout and coverage ratios by sector
Both payout ratios and dividend coverage ratios vary across industries because different sectors have different cash needs and growth patterns. Here’s what typical ranges look like across major sectors:
Mature sectors. Utility providers and long-running consumer staples companies fall into this category. Because these companies grow slowly and steadily, they don’t need huge influxes of cash to expand.
Payout ratios: commonly 60% to 80%
Dividend coverage ratios: often in the 1.2 to 1.7x range
Growth sectors. Fast-growing companies like tech startups and medical device businesses need to reinvest as much money as they can to support research and development and bring new products to market. Sometimes they don’t pay a dividend at all.
Payout ratios: often 20% to 40%
Dividend coverage ratios: usually 2.5x and above
Cyclical sectors. Companies that ebb and flow with economic cycles (such as industrial businesses) typically offer lower payout ratios, since they need to keep cash on hand to weather downturns.
Payout ratios: typically on the lower side
Dividend coverage ratios: ideally 3x or higher during strong periods, to provide a safe buffer when earnings get tight
Real estate investment trusts (REITs). By law, REITs have to pay out most of their earnings as dividends. That means their ratios look very different from other companies, but it’s not always a red flag.
Payout ratios: often very high, which is normal for REITs
Dividend coverage ratios: better evaluated using cash-flow-based measures rather than earnings
What to look for in dividend ratios
Payout ratios and dividend coverage ratios are important when deciding whether or not to invest in a dividend-paying company. They offer a sense of how sustainable a dividend really is. But ratios for a single year don’t tell the complete story. Investors need to know what patterns to pay attention to and what red flags to be on alert for.
Look for steady, long-term trends. Look at a company’s ratios for the past five to 10 years. A payout ratio that stays fairly consistent or a coverage ratio that remains comfortably above 1x is often a sign of disciplined management and reliable, well-managed cash flow.
Understand what’s behind temporary spikes and dips. Sometimes a payout ratio jumps suddenly, or a coverage ratio dips dramatically, but not always because the dividend changed. Earnings often fall during economic downturns, sector volatility, or an unusual business event. It’s not a red flag as long as the earnings (and ratios) normalize afterward.
Pay attention to what management says, and what the ratio does. Many companies publicly state the target payout ratio range they aim to pay. If the company stays within that range over a period of many years, it’s usually an indication of good management and sustainability. But if the payout ratio repeatedly climbs above that target, or the coverage ratio shrinks while earnings stay flat, it could be a warning sign that the dividend is becoming harder for the company to sustain.
Watch for profit swings. When a company’s profits change dramatically from year to year, both ratios can become less reliable and less helpful methods of evaluating a dividend.
Limitations of dividend ratios
Payout ratios and dividend coverage ratios are useful, but they do have limitations. Because they’re based on a company’s reported earnings, they can be distorted by different factors. For instance, write-downs and one-time gains and losses can cause a company’s earnings to swing drastically in one direction, which in turn can distort the ratios and make a dividend look safer or riskier than it actually is. Different industries also use different accounting standards, which can make it difficult to fairly compare companies.
That’s why it’s a good idea to look at payout ratios in conjunction with other financial metrics, like debt levels, cash flow, and the company’s history of maintaining or increasing its dividend.
Dividend growth: the advantage of compounding
Some companies regularly increase their dividend payments, which can have a positive compounding effect for your portfolio if you reinvest them. When you reinvest those dividends, you’re buying more shares, which can further boost your future dividend income and enhance your total returns.
How to assess dividend growth
If you’ve zeroed in on a company that has historically offered dividend growth, the next step is to assess whether that growth is sustainable and the dividend is reliable. A few simple indicators can help you make that call:
Growth rate: How fast has the dividend grown over the past five to 10 years? Slow and steady, or fast and furious?
Consistency: For how many consecutive years has the company raised its dividend?
Sustainability: Is the dividend growth clearly backed by increasing earnings and cash flow?
How to anticipate dividend growth
To evaluate whether a company can continue raising its dividend, look for signs of long-term strength:
Earnings growth: Is the company consistently generating more profit?
Room to expand: Does it operate in markets where demand can grow?
Competitive strength: Can it maintain or expand its competitive position over time?
How dividends fit into total return investing
Dividends are just one piece of what you earn from a stock. The other piece is the change in a stock’s price. Total return investing looks at both: the income you receive from dividends and the growth in the value of your shares. When you reinvest those dividends, they buy more shares, which can boost your future returns — the compounding effect we just talked about. That’s why many long-term dividend investors think in terms of total return rather than focusing only on dividend income or stock price growth.
Common pitfalls of dividend investing and how to avoid them
As with any investment strategy, dividend investing isn’t a perfect science. Here’s how to avoid common mistakes and safeguard your investment decisions.
Chasing the highest yields. Super high yields (dividend income expressed as a percentage of the stock’s current price) look attractive, but they can actually be a sign of financial distress or a dividend payout that’s unsustainable. To avoid getting caught up, compare a company’s yield with its industry norms and make sure its earnings and cash flow can comfortably cover its dividend payments.
Overlooking dividend cut risk. When a company reduces its dividends, the hit for investors can be double: a decline in income and a falling stock price. Cuts can’t always be avoided, but you can try to mitigate the risk. Look at payout and coverage ratio trends for multiple years, check to see whether the company’s dividends have held up during past downturns, and steer clear of companies whose dividends have historically grown while earnings have remained flat or declined.
Letting your portfolio become too concentrated. Dividend portfolios are often heavy in sectors like utilities, consumer staples, and REITs. Like any undiversified portfolio, this creates blind spots and risk. If you want to invest in dividend-paying companies, make sure you seek out a variety of sectors, mix growth stocks with stocks from mature companies, and size your investments based on how reliable the dividend seems to be.
Misunderstanding timing and taxes. Not knowing how dividend dates and tax rules work can lead to surprises and poorly timed trades. To receive the next dividend payment, you need to own the stock before the cutoff date that determines who qualifies for the upcoming payout (called the ex-dividend date). You also need to be aware that dividends are taxed differently depending on whether they’re considered eligible or noneligible (or qualified vs. ordinary in the U.S.), which can affect how much of that dividend you keep after taxes. Eligible dividends receive a larger tax credit, meaning they generally result in a lower tax bill for Canadian investors.
There’s no single formula for successful dividend investing, but understanding the ins and outs of how dividends work and how to evaluate them can help you make more confident decisions. By focusing on strong companies with healthy dividend trends and the right balance of income and growth, you can build a dividend portfolio that grows surely and steadily over time. And when you look at dividends through a total return lens, you get an even better view of how they can contribute to your long-term wealth-building strategy.
