Eight times to avoid dividend stocks

Dividends are payments made by companies to shareholders. They can be very appealing, but there are many reasons to avoid them. 

Richard Drew/AP/File
Specialist Glenn Carell works at his post on the floor of the New York Stock Exchange Wednesday, May 29, 2013.

Dividends, which are quarterly payments made by companies to shareholders, can be a very cool thing. Who doesn't love the idea of getting free money just for owning a stock?

Shares of companies with solid dividends can be an important part of any investment portfolio, and some of the nation's most iconic companies have a track record of paying solid dividends to shareholders every quarter. But there are many cases where a dividendstock should be avoided. Here are eight times to stay away from dividend stocks.

1. When You're Seeking Growth

Dividends are nice when you're seeking income, but often, companies pay high dividend yields because they can't offer investors much share growth. If you are young and have a long way to retirement, it should be growth you're seeking. Real estate investment trusts and utilities are examples of companies that pay good dividends and offer stability, but little in the way of share price upside.

2. When a Yield Is High Because the Price Is Low

If you look at a list of stocks with the best dividend yields, it will often include a number of struggling companies. A low stock price isn't necessarily a bad thing if you're getting a bargain, but beware of investing in companies that are dealing with major operational problems with no clear path to improvement. If a company continues to struggle, it may cut its dividend, anyway.

3. When the Company Would Be Better Off Not Offering Dividends

It's nice to get a dividend, but sometimes you'd rather see the company use that money to invest in the business, expand, or make acquisitions. A young technology firm, for instance, would probably be better off not paying a dividend.

4. When You Are Using a Tax-Deferred Account

If you have your retirement savings in a traditional IRA account, your earnings upon withdrawal are taxed at the ordinary income rate. This includes dividends that you may have accumulated over time. If you have dividend stocks in a taxable brokerage account, you pay the the prevailing dividend tax rate instead, which is usually lower. And any gain — including dividends — from stocks in a Roth IRA are not taxed at all upon withdrawal when you retire.

5. When a Company Is Low on Cash

Generally speaking, investors like to see a company pay for its dividends and capital expenditures with cash on hand. Sometimes a company needs to borrow to meet these obligations, and that's a red flag that the company may have to cut its dividend down the road. Read a company's balance sheet to determine its cash flow situation, then figure out if the dividend is sustainable.

6. When the Stock Is Too Pricey for the Dividend

Dividends are nice, but there's very little point to paying $100 per share for a 25 cent per share annual dividend. Under this scenario, you're only getting a dividend yield of .25% — hardly a king's ransom. But if the stock is trading at $40 and the dividend is $1, you'll have a much nicer yield of 2.5%.

7. When Interest Rates Are High

Dividend stocks can be very popular when interest rates are low, because they can offer a better return than cash saved in the bank. Why keep your cash in the bank getting less than 1% interest annually when you can get 3.35% by investing in Coca-Cola? But the opposite is also true. At various times in history, bank interest has exceeded most dividend yields. High interest rates can also be a killer for Real Estate Investment Trusts, which are impacted by the housing market and have some of the market's highest dividends.

8. When There's No Record of Dividend Growth

It's tempting to be drawn to the current yield of a dividend stock, but it's better to examine whether the company has a history of increasing its dividend on a regular basis. A company's true health will shine through if it can routinely make dividend payments and even boost those payments every year. So-called "dividend aristocrats" are those firms that have increased dividends each year for 25 straight years, and the list includes many of the most prized blue chip stocks including Coca-Cola, AT&T, Wal-Mart, and ExxonMobil.

This article is from Tim Lemke of Wise Bread, an award-winning personal finance and credit card comparison website.

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