You may have heard of blue chip stocks, but what are blue chip companies, and why are they a good investment?

For people new to investing, there are some important definitions that will help you navigate the world of stocks. Two terms you will come across often are “blue chip stocks,” and “blue chip companies.”

What are blue chip companies?

Blue chip companies are typically defined as firms whose stocks have a national reputation for quality, reliability and the ability to operate profitably in good times and bad. However, the problem is that “reputation” plays a key role in the definition.

Many companies acquire a blue-chip reputation by displaying the qualities that the definition suggests. Others get it through a strong public relations effort or by being in the right industry or business situation at the right time and place. Regardless of how it got there, this blue-chip label sticks with companies long after they quit living up to it.

You can still look at blue chips as the strongest and most secure stocks on the market. Just be sure you look at the stock’s qualities and not just at the label.

In plain English, when you ask, “what are blue chip companies?” the answer is usually a company you already know. Companies that have stood the test of time, and pose little risk to an investor even in the worst of financial times, are blue chip companies. Coca-Cola and Apple are two good examples.

When assessing blue chip companies, you need to ask: What are they doing to remain vital? These companies hold strong positions in healthy industries. They also have strong management that will make the right moves to remain competitive in a changing marketplace.

Stocks like these give investors an additional measure of safety in today’s volatile markets. And the best ones offer an attractive combination of low p/e’s (the ratio of a stock’s price to its per- share earnings), steady or rising dividend yields (annual dividend divided by the share price) and promising growth prospects.

Canadian dividend stocks: a strong investment in any market

A company with a long-term record of paying dividends is generally one that is most deserving of the “blue chip” label in its traditional sense. Dividends, after all, are much more stable than earnings projections. More important, dividends are impossible to fake—either the company has the cash to pay them or it doesn’t.

That’s not to say there won’t be surprises that affect every company in a particular industry. But well-established, dividend-paying stocks have the asset size and financial clout—including solid balance sheets and strong cash flow—to weather market downturns or changing industry conditions.

Canadian dividend stocks offer both capital-gain growth potential and regular income. In fact, dividends are likely to still be paid regardless of how quickly the price of the underlying stock rises.

Dividends from Canadian companies come with a tax credit, to reflect corporate income taxes. This cuts your tax rate. (Note: the credit is non-refundable and can only offset income taxes owed. But you can transfer it to your spouse under certain conditions.)

What are blue chip companies and should you invest?

It’s realistic to assume dividends from blue chip companies will continue to contribute around a quarter of your total return. In addition:

1. Dividends can grow. Stock prices rise and fall. Interest on bonds holds steady at best. But dividend paying stocks like to ratchet their dividends upward—hold them steady in a bad year, raise them in a good one. That gives you an advantage against inflation.
2. Dividends are a sign of investment quality. Some good companies reinvest profit instead of paying dividends. But fraudulent and failing companies are hardly ever dividend paying stocks. So if you only buy stocks that pay dividends, you’ll automatically stay out of almost all the market’s worst stocks.

For a true measure of stability, focus on those companies that have maintained or raised their dividends during the recent recession and stock-market downturn. That’s because these firms leave themselves enough room to handle periods of earnings volatility. By continually rewarding investors, and retaining enough cash to finance their businesses, they provide an attractive mix of safety, income and growth.

Do you have experience with blue chip companies? Let us know in the comments.