Investors seeking to maximize their income potential often turn to dividend stocks as a reliable source of returns. But with so many options available, it can be daunting to identify the best dividend stocks for your portfolio. That's where the Morningstar Dividend Yield Focus Index comes in. In this article, we will delve into the intricacies of this index and explore how it can help you make smarter investment choices. We will also discuss the pros and cons of investing in dividend stocks versus dividend funds and provide practical advice on how to successfully navigate this lucrative market. Additionally, we will showcase the top 25 high dividend stocks to consider for your investment strategy. But first, let's understand the essential concepts of dividend yield and how it relates to the payout ratio.

Understanding the Morningstar Dividend Yield Focus Index

The Morningstar Dividend Yield Focus Index is a specialized subset of the Morningstar US Market Index, which represents 97% of the total equity market capitalization. This index specifically tracks the top 75 stocks that have high dividend yields and meet our rigorous screening requirements for quality and financial health.

How do we select stocks for this index? We only include securities that offer qualified income dividends, while excluding real estate investment trusts. Furthermore, our selection process involves evaluating the quality of companies using the Morningstar Economic Moat and Uncertainty Ratings. Specifically, companies must have a narrow or wide moat rating and a Low, Medium, or High Uncertainty Rating. Companies with Very High or Extreme Uncertainty Ratings are excluded. In addition, we utilize a distance-to-default measure to screen for financial health. This measure uses market information and accounting data to assess a company's likelihood of defaulting on its liabilities, providing insight into its balance-sheet strength.

The index includes the 75 highest-yielding stocks that pass our quality screening criteria, and these stocks are weighted based on the total dividends paid by each company to investors.

Comparing Dividend Stocks with Dividend Funds for Income Investing

When it comes to investing in dividend stocks, there are two primary methods: through mutual funds, such as index funds or exchange-traded funds (ETFs), that hold a portfolio of dividend stocks, or by directly purchasing individual dividend stocks.

Dividend ETFs or index funds offer investors the opportunity to own a diversified selection of dividend stocks within a single investment. With these funds, investors receive regular dividend payments and have the option to take them as income or reinvest them. Notably, dividend funds provide the advantage of instant diversification, ensuring that if one stock in the fund cuts or suspends its dividend, investors can still rely on income from the other stocks.

» Are you interested in generating passive income? Discover what passive income is and how to start earning it.

Reinvesting dividends, whether through dividend stocks or dividend funds, can significantly enhance investment returns. Dividends generally increase the overall return of a stock or dividend fund by a few percentage points. For example, if we consider the historical data, the total annual return (including dividends) of the S&P 500 has been on average approximately two percentage points higher than the index's annual change in value.

This difference can have a significant impact on investment growth. By using NerdWallet’s investment calculator, we can observe that a $5,000 investment that grows at an annual rate of 6% over 20 years could potentially reach over $16,000. However, if we increase the growth rate to 8% to account for dividends, that same $5,000 investment could grow to over $24,000.

In general, it is advisable to allocate a major portion of your portfolio to index funds for the reasons mentioned above. However, there are benefits to investing directly in individual dividend stocks as well.

While investing directly in dividend stocks requires more effort on the part of the investor, including conducting research to ensure a good fit within the overall portfolio, it allows investors to create a customized portfolio that may yield higher returns compared to a dividend fund. Additionally, expenses can be lower with dividend stocks as ETFs and index funds charge an annual fee, known as an expense ratio, to investors.

» Learn more about dividend ETFs.

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How to invest in dividend stocks

Building a portfolio of individual dividend stocks requires time and effort, but for many investors, it offers significant benefits. Here’s a step-by-step guide on how to purchase a dividend stock:

1. Find a dividend-paying stock. Many financial websites and online broker websites allow you to screen for stocks that pay dividends. Below, we have also provided a list of high-dividend stocks.

2. Evaluate the stock. To gain deeper insights into a high-dividend stock, begin by comparing its dividend yield to those of its peers. If a company's dividend yield is substantially higher than similar companies, it may raise concerns. At the very least, it warrants additional research into the company's fundamentals and the sustainability of its dividend.

Additionally, analyze the stock's payout ratio, which indicates how much of the company's earnings go toward dividends. A payout ratio that is excessively high, typically above 80% (although industry norms may vary), suggests that a significant portion of the company's income is allocated to dividends. In some cases, the payout ratio can exceed 100%, implying that the company might be taking on debt to finance dividend payments. (For a comprehensive guide on researching stocks, read our full article here.)

3. Determine the quantity of stock to purchase. Since diversification is crucial when buying individual stocks, you'll need to decide what percentage of your portfolio each stock should represent. For instance, if you're buying 20 stocks, you could allocate 5% of your portfolio to each one. However, if a stock carries higher risks, you might want to invest less in it and allocate more money to safer options. Additionally, if you plan on reinvesting dividends, you must recalculate your cost basis, which refers to the original amount you paid to purchase the stock.

The main consideration when purchasing a dividend stock is the safety of its dividend. Dividend yields above 4% should be analyzed meticulously, as those exceeding 10% can be considered highly risky. A very high dividend yield could indicate an unsustainable payout or market factors causing investors to sell the stock, leading to a higher dividend yield. Furthermore, investors with taxable brokerage accounts and high income brackets should be aware that dividends in these accounts result in taxable events in the year they are received. This differs from stocks that do not pay dividends, where taxation mostly occurs upon selling the stock.

» Need more details? Learn how to buy stocks.

Below, you can find a list of the top 9 highest-dividend stocks based in the U.S., ordered by their annual dividend yield. The list also considers the 5-year average dividend growth rate.

BP Prudhoe Bay Royalty Trust

North European Oil Royalty Trust

Alliance Resource Partners, L.P.

NXG Cushing Midstream Energy Fund

Source: Finviz. This stock data is current as of June 30, 2023, and is intended for informational purposes only, not for trading purposes.

Please note that the list above does not include real estate investment trusts (REITs), which are another type of income-generating equity investment. To learn more about REITs, check out our article on the best-performing REITs.

Top 25 Dividend Stocks with a Strong Track Record

The high-yield dividend stocks listed below have maintained or increased their dividends consistently over multiple consecutive years, starting with the shortest streaks.

Understanding the Dividend Yield Metric

The dividend yield is a percentage that represents the income (in the form of dividends) paid by a company to its stock investors relative to the stock's price. Dividend yield is just one of many metrics that investors can consider when assessing whether a company's stock would be a valuable addition to their investment portfolios.

The Relationship between the Payout Ratio and Dividend Yield

While dividend yield compares dividend income and stock price, the payout ratio compares dividend income and company earnings. In simpler terms, it demonstrates how much a company pays its investors relative to how much it retains for its own usage. The payout ratio can provide insights into the income that investors can potentially anticipate in the future. A payout ratio that is excessively high, where the company pays investors significantly more than it reinvests in itself, may indicate limited room for future dividend growth. It can also be an indicator of potential financial trouble for the company.

Investing in dividend stocks can be a profitable strategy for those seeking a steady income stream. From understanding the Morningstar Dividend Yield Focus Index to weighing the pros and cons of dividend stocks versus dividend funds, there are several key factors to consider when building a dividend portfolio. By following the tips outlined in this article, investors can confidently navigate the world of dividend investing and make informed decisions about the top 25 high dividend stocks. So, whether you're a seasoned investor or just starting out, take advantage of the dividend yield and payout ratio to build a diversified portfolio that generates consistent returns. Start investing in dividend stocks today and reap the rewards of a well-structured income-focused investment strategy.