Last Updated on 21 November, 2023 by Samuelsson
Investing in stock dividends does seem like a great source of some “easy” income. Let’s look at how to start investing in dividend stocks.
But hold your horses before you go in blindly in a moment of excitement with false hopes. In an age, where the internet has made it relatively easy and cheap to trade, why would an investor want to hold on to a stock?
The answer is the dividend!
First, let’s look at what exactly is a dividend:
The first concept you need to understand is that a dividend is not “income”. A dividend is in reference to the distribution of earnings to a company’s shareholders, eligibility for which is decided by the board of directors.
Typically for dividend-paying companies, the shareholders who own the stock before ex. dividend dates are entitled to the next dividend. That’s why stocks drop on the ex-dividend date. Cash is transferred from the company to the shareholders. It’s a capital distribution.
Dividends originate from the company’s net profit, a big chunk from which is kept aside as retained earnings – meant to be used for the company’s present and future business engagements. The rest is allocated in the form of dividends to the shareholders.
However, many companies, which are in pursuit of maintaining an even track record of dividend payment, tend to pay dividends in spite of insufficient profits. Dividends are typically paid in the form of cash but are also issued in the form of shares of stock.
The company sets the frequency of the dividend payout, the time frame for which is generally scheduled linearly like monthly, quarterly, or annually. You may also find companies issuing special dividends in addition to the scheduled dividends, by the grace of significantly improved business growth and financial health.
Dividends can be considered as a token of appreciation for the trust that shareholders invest in the company. There are certain companies with a more predictable profit that holds a great record of issuing regular dividends. Sectors like consumer staples, healthcare, pharmaceuticals, etc. are observed to be focused on regular dividends payout.
Companies that are still in their startup phases or in high growth sectors like technology or biotech, may opt to not pay a regular dividend. As these companies are still in their early development stages, high costs focused on business development, research, or operational costs may result in a lack of funds to pay dividends.
A company’s reason for paying or not paying dividends actually depends on how you perceive it. It’s a two-edged sword if you go by individual perspective.
For instance, a company paying regular dividends can be perceived as having great financial growth and earnings. On the contrary, one can also doubt the company’s lack of business expansion and investing for its own growth. In the scenario where a company is lacking in issuing dividends, it could be the result of either insufficient profits or retained earnings.
There is a reason why dividends are told to be risky. First things first, don’t confuse them with coupons from a bond. Where dividends come from the net profit of a company’s earnings and are distributed if the company chooses to pay, coupons on the other hand are bond interest, obligated to be paid, typically on a semi-annual basis.
Majorly the difference is, unlike coupons, dividends aren’t compulsory. A company can choose to allocate dividends heavily dependent on the company’s profit and how much they choose to save as retained earnings for their business growth and higher returns in the future. Furthermore, the bond owners are paid before equity owners if the company faces bankruptcy. A coupon will always be safer than a dividend.
What is the dividend yield?
A dividend yield is typically an estimation, expressed in a percentage. It is a ratio that reflects how much dividends are paid out by a company every year with respect to its stock price. For instance, let’s say that a dividend has neither lowered nor raised, so if the price of the stock falls, the yield will rise and vice versa, the yield will fall when the price of the stock rises. As the stock price and dividend yield are relative to each other, the yield can look disturbingly high for stocks that are dropping in value.
Start-ups that are small and in a stage of quick growth tend to pay lower than normal dividends than established and mature companies in the same industry. Typically, established companies that have limited growth, pay out more in dividends and might therefore have a high dividend yield, depending on the multiple valuations.
There are many components that justify the kind of dividend that a company pays.
For instance, the dividend yield is relatively very high in real estate investment funds. However, those yields only come from their ordinary dividends rather than qualified ones.
Like REITs, business development companies are generally seen to have high dividend yields too. The reason being, the structure of these very companies obligates them to allocate a major chunk of the funds to their shareholders. This process of “pass-through” allows companies to not pay taxes on the profits allocated as dividends. Although, the shareholder in this scenario has to take this dividend as general income and further pay taxes on them.
The general formula for dividend yield is:
Dividend yield = Annual dividends per share/price per share
The dividend yield can be taken out of the company’s last year’s financial report. It is imperative to remember that the older the reference data is; the less relevance it holds for an investor.
On an alternate approach, an investor can also sum the dividends of the last four quarters, trailing the 12 months of data. The approach of taking the dividend of the last quarter in case of quarterly distribution and multiplying it by four and using the result as the figure for annual dividends per share in yield calculation can only be applied in a situation where the dividends are even throughout all the quarters.
It is also imperative to consider that many firms follow the practice of paying small quarterly dividends with a huge annual dividend. If the dividend yield is calculated based on the larger dividend distribution, it is quite normal to find an inflated yield. There are different methods of calculating dividend yields but it will require analyzing a company’s long-term history of dividend payments in order to decide which method to use to produce accurate results.
Dividend yields become a great part for old investors like retirees that are reliant on dividends as their source of “income”.
For such investors, the dividend yield of their portfolio can have a rather significant impact on their own finances. This makes it crucial for such investors to choose companies with a long history of records in dividend payouts and a strong financial stand.
For the rest of the investors, like the young ones with higher interest in a company’s growth and retained earnings to finance their own growth, the dividend yield is not as significant.
The historical returns are like this from 1972 until the end of 2019, according to Hartford Funds:
- Dividend payers: 12.79% annual return
- Non-payers: 8.57% annual return
- Dividend growers & initiators: 12.87% annual return
- Dividend cutters & eliminators: 10.88% annual return
This amounts to a huge difference compounded over many years: 10 000 invested is worth 370 000 for dividend payers after 30 years, while for non-payers the end result is only 118 000. Even those stocks which either cut or eliminated the dividend perform better than non-payers.
But keep in mind that these numbers are averages and generalizations. Many companies that don’t pay a dividend could pay a dividend if they wanted to: Berkshire Hathaway, Adobe Systems, Google, Facebook, to name the most obvious.
As such, dividend stocks can serve as useful heuristics of where to start looking for quality stocks. However, you risk eliminating the really good compounders which can reinvest the earnings at high incremental returns. This is a much more rational way of compounding than reinvesting a dividend (more later in the article).
Before going in further, remember to stop chasing higher yields and don’t invest only for dividend income. The research by Hartford Funds indicates the stocks with the 20% highest yield perform the worst among the dividend payers. In a previous article, we discussed what is a good dividend yield.
It is also a good idea to analyze the stability of the sector or industry in which you are investing. Some sectors are better both in terms of stability in “income” and cash flow. For example, commodity stocks are highly dependent on factors outside of management’s control and thus more unlikely to become good and stable dividend stocks.
There are many reasons why investors are inclined toward dividend-paying stocks. Mostly, because dividends become a source of regular “income” for the investors, flowing monthly, quarterly, or annually with a sense of safety intact.
Despite industry, sector, or news that influence the overall economy, the stock prices are more prone to volatility than dividends, so investors generally aim for stability in the form of dividends to avoid behavioral mistakes, to sell during a panic for example. What happens to dividends in a bear market?
With a better business model, dividend stocks can be less volatile and a safer investment on that note. But aside from that, there are cases of many companies that just carelessly throw away cash in dividends due to a lack of opportunities for potentially higher returns.
By building a solid portfolio of quality companies you can possibly have an “income stream” from dividends that grows more or equal to the inflation rate. In a world where central bankers are desperate to keep interest rates low, the income from risk-free government bonds is about zero. The inflation rate runs at 2-5% in most Western countries, and hence many investors aim to build a portfolio that has the capability of withstanding market fluctuations as well as inflation.
Compounding is referred to as reinvesting in order to increase additional earnings. In the bond market, this is referred to as the interest on the interest. So basically in the case of dividends, you reinvest them to buy extra shares, instead of cashing the dividend out.
This could indeed be a good reinvestment strategy as it is easy, flexible, and consistent. The research by Hartford Funds is calculated by reinvesting the dividends. By reinvesting dividends and because of compounding, one can easily increase their long-term returns. As the dividends are used to buy further shares, the dividend automatically increases for the next time, which can allow you to buy more shares and the cycle goes on until you decide to cash out.
But don’t fool yourself! Most dividend reinvestments are done at a premium to the book value while being distributed at book value:
This is why internal compounding is much better than external compounding:
Internal compounding is the situation where the retained earnings are directly reinvested into the existing business instead of distributing it to the shareholders. External compounding involves returning the retained earnings to the shareholders through dividends and leaving compounding up to them. All things equal, investors are better off letting the capital compound in the company:
There is a misconception when the management of the company claims the dividends for the benefit of shareholders, but it’s actually the management that is at the lack of reinvesting into opportunities. So they leave it up to their shareholders to invest their time in reinvesting the very funds.
It is always better to keep a checklist of things in mind to verify about the dividend payers before one starts depending on dividend stocks:
Large companies have a tendency to have a long history of revenue and profits, hence are considered easier to analyze. That being said, always take a look at both EPS (earnings per share) and DPS (dividend per share).
Moreover, it is highly advised to consider several years of earnings before coming close to accepting that the dividend is safe or not. Companies with a long history of growing the dividend, generally have major analysts following and tracking them, hence you can easily find pre-existing analysis and other information on them.
But the most important question is this:
How likely is it that earnings are much higher 10-20 years into the future? Future dividends need to come from improved earnings and cash flow.
History is what has happened in the past, and might give you clues about the quality of the company and its products, services or management. It is true that any company’s past performance can’t possibly guarantee its future, but it can surely help to predict it, especially when it comes to dividends.
When it comes to companies that have uninterrupted growth in their dividends every year, they tend to continue doing it. That’s why it is highly imperative to check at least several years of dividend history.
The payout ratio lies in the highly important category when assessing dividend stocks. The payout ratio of a company is referred to as a simple ratio of the dividends paid, to the company’s earnings.
For instance, let’s say a company annually earns a profit of $8 per share and pays an annual dividend of $2. In this case, the payout ratio is 25%. We recommend having a look at the cash flow per share as well. After all, the dividend is paid in cash.
It is actually better for a company to have a lower payout ratio as it reflects that the company owns sufficient funds in profit to cover its dividends and leave room for dividend growth.
A high payout ratio can signal an unsustainable dividend that may be in danger of being cut. However, US companies that fall under real estate investment trusts (REITs) and business development companies (BDCs) are exceptional to the rule since they are obligated to pay at least 90% of profits to the shareholders. Hence, in such industries, a high payout rate isn’t exactly a cause of alarm.
Debts are not always bad, but anything in excess is harmful and excessive debt can be fatal for a company. Especially, in case of a high-interest expense, the profits can drop off and leave the company struggling to make payments on its debt and further in paying dividends.
It’s a basic sense that if the majority of a company’s profit is gone in paying overbearing interests, then they would lack both in dividend distribution and retained earnings, potentially compromising any hopes for high returns in the long run.
Debt covenants are typically like agreements between a company and its lenders, stating certain rules or guidelines set by the lenders to which the company will function, also known as financial covenants. But the purpose of debt covenants is not to place unnecessary obligations on the borrower, rather they are meant to align interests and to aid problem-solving between the lender and the management (borrower).
In the case of negative debt covenants where it constitutes what a borrower can’t do, it can include paying cash dividends only over a certain threshold.
By definition, dividends might suggest good management in the company. As the dividend is paid in cash, the company must have it in hand. So it becomes impossible for the management to fake it. It may be possible to tamper with things on paper reports or sales profit but one can’t fake cash payout dividends to shareholders.
Does management have skin in the game? Are interests aligned? All things equal, it’s preferable to choose a company where management owns a substantial number of shares. Skin in the game should motivate the management to rational capital allocations.
Stocks, where the revenues are often given by factors outside management’s control, are in most cases not good investments. We name for example commodity and cyclical stocks. Where do you see a sector in 10-20 years?
Last, but not least, you must have an eye on the valuation. High valuation doesn’t necessarily mean you should pass. A quality company that has high returns on invested capital, can easily defend high multiples today.
High yields stem from the high-value dividend distribution. Although a high yield looks tempting, it also reflects on the lack of expense dedicated to the potential growth of the company. So every dollar the company pays to its shareholders as dividends is one dollar less for them to reinvest in their business growth and potentially higher returns.
By reinvesting in the company, an investor may not earn dividends, but have the possibility of earning higher returns when the value of the stock surges.
Investors are highly recommended against analyzing a stock over dividend yield alone. The data could be old, faulty, or simply insignificant to the information an investor needs.
Companies with high dividend yields can be a reflection of their falling stock and a bleak future. If the company experiences enough decline in stocks, it could fall heavily on reducing dividend value or potentially eliminating them completely.
Additionally, please keep in mind that many companies could pay a dividend but chose not to – they rather reinvest into the business.
How to start investing in dividend stocks – conclusion
A dividend investor should first ask himself why he or she invests in dividend stocks. Why limit yourself? We have previously debunked dividend investing. Furthermore, you can also invest in non-dividend stocks and sell shares to get “income”.
The aim is to be open-minded or more like agnostic and to know what you are doing. Keep in mind the various components that influence the stock and what adds to your earnings in the long run. Dividends are not obligatory from a company’s end; hence, they are riskier and can be eliminated. But with the right strategy, analysis, and consideration, they also have a potential of significantly higher returns by compounding the dividends.
Factors like industry or sector-specific dividend stock, debts, earnings history of the company, management, strategy, and payout ratios, add accuracy to the analysis that is needed to evaluate a dividend stock before investing.
Moreover, as much as the value of the stock and dividends play a role while deciding investment strategy in dividend stocks, a brief take on the company’s decision of increasing or reducing dividends is as important.
At the end of the day, all that matters is TOTAL returns, not dividend returns. This is how to start investing in dividend stocks.
– Is investing in dividend stocks a good idea?
Historical returns show that dividend-paying stocks often outperform non-payers. However, it’s essential to diversify and not invest solely for dividend income.
– How does compounding work in dividend investing?
Compounding involves reinvesting dividends to buy additional shares, increasing future dividends. Internal compounding within the company is often considered more favorable than external compounding through dividends.
– Why should investors avoid chasing high yields?
High yields may indicate a lack of investment in the company’s growth. Investors are warned against focusing solely on high yields, as companies with declining stocks may reduce or eliminate dividends.