Dividends are a great thing. Investors that overlook the importance of dividends in building wealth are missing out a serious opportunity to watch their holdings grow.
I am a big advocate of keeping at least a portion of your holdings in dividend-paying stocks, and using a dividend reinvestment program to put your income back into the market, but there is a big problem that some investors struggle with when it comes to investing in dividend stocks. That problem is overlooking the underlying security’s value and being blinded simply with the stock's yield.
It is easy to fall into this trap. When you screen for dividends, a lot of stocks with high yields will pop out. Yields of 5% or more can be very tempting, but if the underlying security is not solid, losses on the stock itself can quickly erase any income that the dividend produces.
Yield on its own is not enough. You have to balance yield with value. Understanding the income from a stock is fairly straight forward… value is little tougher to get a grip on. Using a stock's P/E ratio is a good way to gauge a stock's value, but even then there is no clear-cut formula. The best approach is comparing the valuation of a stock against other stocks in the same sector. If all other things are equal, the stock with the lower P/E should present the better value, and stocks with P/E ratios sharply higher than their peers should be considered overvalued.
Each of the following dividend-paying stocks appear to be overbought at the current time, and investors should consider looking for other stocks to fill up the dividend portion of their portfolios.