Let's say you've come across a bundle of money and decide to invest it instead of spending it.
You know two neighbors who each run a business in which you can invest, Mr. Smith and Mr. Jones.
Both have owned their businesses for over 30 years and are known successes.
However, each operates quite differently.
Mr. Smith set up a retail store and carefully reinvests some of his profits every year.
He also regularly pays out a portion of his profits to his investors each year.
Mr. Jones, on the other hand, is setting up a chain of retail outlets.
Because of his aggressive approach to growing the business, he reinvests all of his profits into his business.
He explains to his investors that much bigger returns will be possible as his empire grows but in the meantime, there are no profits paid out annually.
Each of these investments can be sold on the open market at any time, but which is a better investment for you?
While both Mr. Smith and Mr. Jones are honest, successful entrepreneurs, your best bet is to put your money with Smith and take advantage of a regular ongoing return on your investment.
Let's explore why…
The Smith vs Jones example offers a simple explanation of the difference between stocks which pay regular dividends and stocks which do not provide a current yield in the form of dividends.
This is not to say that non-dividend paying stocks don't have a place in your portfolio, but in the long run all investments should be earning enough income to sustain your lifestyle.
This is why, even if both investments are good, the investment offering an ongoing payout is always a better choice.
Your investment with Smith is already generating income but the investment with Jones must later be sold and converted to an income-producing investment.
That is, unless Jones changes his method of operations and decides to stop reinvesting all profits and start paying out dividends to his investors. #NotLikely
This is a simplified overview of dividend stocks, but before you run out and start buying dividend-paying stocks, there is more information you will need to make an educated assessment.
Specifically, you want to know how to:
- Calculate your yield to determine what rate of return you can obtain from a dividend stock
- Screen for dividend stocks to come up with a group of candidates for your investment portfolio
- Analyze the company to ensure it can sustain its dividend payments
- Decide how much stock to buy so it balances with your other investments
- Choose the dividend reinvestment plan best for you, either automatic or manual
So let's dig right in and learn the ropes!
Calculating Your Yield
The first thing you need to know is how to determine the yield you will get on an investment.
This calculation will rely upon one main assumption: that the dividend payment remains constant over the life of the investment.
Of course, you would love to see that dividend payment increase over time, but most important is that the dividend payment does not decrease.
While no one can predict the future, you can get a good sense of the likelihood of sustainable, even payments by reviewing the company's past performance.
Your initial yield calculation is quite simple: it is the amount of dividend paid out divided by the price you paid.
For instance, if you bought a stock for $10.00 per share and in the first year you receive dividends totaling $0.30 for each share, your dividend yield is 3% ($0.30/$10.00 = 0.03, or 3%).
Over time, the ideal scenario is holding a stock whose dividend payment increase over the years.
This is not always a matter of luck but a matter of learning basic analysis to assess a company's strength and stability.
Yield does not equal total return, which can't be determined until you sell the investment.
Many investors make the mistake of thinking they lost money when their stock drops from $10 per share to $9 per share.
The truth is, you don't make or lose money money until you sell the investment.
Share prices fluctuate, but your income yield can always be calculated.
Screening for Dividend Stocks
Fortunately, now that everything is readily available online, you don't have to be an expert in stock analysis to understand screening for dividend stocks.
The first stage is to find stocks paying acceptable yields.
This is done based upon their past dividend payment history and the current market price of their shares.
Specifically, find stocks paying annual yields of at least 4%.
Most people say higher-yielding dividend stocks should be avoided. I disagree. My personal yield target across my entire portfolio is 9%.
Also, pay attention to names you know. Coming across a well-known company paying strong dividends is worth a closer look.
If you want to play it safer (ie make money slower), keep an eye on the stocks that form the Dow Jones Industrial Average (DJIA).
The DJIA is comprised of 30 major corporations, including Microsoft, Apple, Walt Disney, and Coca-Cola.
For this group, finding a stock with a yield exceeding 2% is considered a good return from a powerhouse company unlikely to collapse any time in the future.
But there are always exceptions to that rule. I'm looking at you, GE.
There are many more factors to consider when screening for dividend stocks, including:
- Payout Ratio – this is calculated by determining the percentage of net earnings that are paid out in dividends. An average payout ratio is about 33%, so finding stocks with lower than average payout ratios likely indicates a company able to sustain its dividends
- Sector/Industry – some industries are historically more stable than other business sectors. Understanding which areas perform better and are less subject to outside influences and fluctuations can aid in determining risk factors for specific companies
- Market Cap – formally referred to as “market capitalization.” This refers to the total market value of the company stock (total outstanding shares multiplied by share price). A higher market cap signifies an established firm with lower risk potential, excellent for conservative investors
- Dividend Payment Stability – examining the past history of dividend payments to stockholders also gives a clear picture as to its reliability and consistency in making dividend distributions
- Earnings Growth Potential – when considering dividend stocks with more upside potential, analyzing its projected earnings growth can indicate a dividend stock on the rise
Once you have found some dividend stocks that pass your first test (i.e., the yield is attractive, they show good stability, fit in an industry in which you are comfortable investing, etc.), performing an analysis of the company is your next step.
Stock analysts are highly-paid and educated folks who spend their lives evaluating companies, so don't feel like you have to compete with that.
The research reports they publish can give you the insights you need.
Also, any publicly traded company provides annual reports of their income and expenses, as well as their assets and liabilities.
The financial statements can be complex and detailed, but to keep it simple, you want to find companies without a lot of debt.
A financial statement of assets and liabilities will reveal this. Be sure that the company is also making more money than it is spending (found on the income/expense statement).
The annual reports also provide past histories, so you can learn about the stability of their dividend payments and the stock prices.
For those faint of heart, stick with solid, steady winners so you are not torturing yourself over volatile stock prices and/or changing dividend payments.
How Much To Buy
Once you have identified a dividend stock that passes your rigorous standards, the next question is how much of it should you buy.
Diversification is just as important as selecting good companies to invest in.
When starting out, you shouldn't have more than 10% of your overall portfolio in one dividend stock.
As your portfolio increases in value, I recommend a basket of at least 20 or more different dividend stocks, or 5% or less of your portfolio for any given investment.
Many companies give you the option to automatically reinvest your dividends by purchasing more of the same dividend stock. This is known as a DRIP.
Others simply pay out their dividends in cash giving you the option to purchase more shares of that stock… or any other stock you want.
When choosing between automatic and manual reinvestment, keep in mind that you can always switch it up if your situation changes or you feel like you're holding too much of one dividend stock.