When you own stock you are a shareholder in the company and, as such, are entitled to a percentage of the earnings generated by the company. The portion of corporate earnings sent to investors is called a dividend. Dividends are typically distributed to investors on a quarterly basis, and some companies even increase their dividend payments over time. By carefully assembling a number of dividend-paying stocks, investors can build their own custom-tailored cash stream portfolio.
Over the years, many investors have discovered the investing genius of dividend-paying stocks as well as the key attributes to consider. They love the often dependable and ongoing dividend payouts, along with the opportunity to reinvest dividends in order to buy more shares of stock. A great number of these dividend-paying stocks are corporations with a long track record of being considered financially sound and they tend to be industry leaders.
The corporations’ strong financial standing provides the potential for the stock prices of these firms to rise steadily over the long term, all the while distributing periodic dividends to shareholders. Many consider high-quality dividend stocks to be the ultimate win-win situation for investors. Investors also love that a number of established dividend-paying corporations will raise their dividends year in and year out.
The firms that pay ongoing dividends that rise over time typically demonstrate outstanding financial health primarily based on the production of reliable cash flow. Free cash flow is where the money from dividend-paying stocks originates. Such companies prove to be stable with less volatile stock prices than some younger, high-growth companies. Their longer life span and proven path to profitability tend to make dividend-paying firms lower risk prospects versus competing smaller firms which do not pay any dividends and are more volatile in price movement.
Thanks to their lower risk profile and consistent payouts in the form of dividends, these income-producing stocks appeal to older investors who need to develop a consistent income flow for their retirement. Additionally, they attract younger investors who are interested in reinvesting dividends to generate even more wealth over the long term as they continue to save for their financial goals.
How to Buy Dividend Stocks
Purchasing dividend stocks are identical to buying any other forms of stock. You must start by opening up a brokerage account. Next, you must fund the account.
Then you begin the research process to track down dividend-paying stocks. You need to investigate those firms that pay out dividends reliably. Fortunately, the job is made considerably easier thanks to modern brokerage account tools and public financial websites. One tool that can be helpful is an investment screener that will assist in listing strong dividend-paying companies with high payouts. A financial advisor can also help you identify high-quality dividend-paying stocks.
There are a few key factors to consider during the research process:
- Analyze the company – This could be the most difficult step yet it proves to be most crucial. Choosing the best dividend stocks involves picking a healthy firm that has the capability of maintaining its dividend payout for many years. It requires some significant time devoted to understanding the corporation’s industry and financial statements as well.
- Uncover the payout ratio – The payout ratio is defined collectively as a firm’s total dividends paid to all shareholders divided by its total net income, or individually as a dividend on a single share of stock divided by the earnings per share of the stock. The payout ratio can reveal several things about a company. If the ratio is high, there is the risk that the company may eventually cut their dividends because they are using a significant portion of their earnings to pay a dividend. This is money that can be reinvested back into the company to cover research & development, capital expenditures, or other items that may help grow the business. Extremely high ratios above 80% may not even be sustainable even if the company wanted to continue paying out dividends. Moreover, it is common for a company’s stock market price to react negatively to news that a company is cutting their dividend so investors can be hurt in two ways.
- Find the company’s dividend payout policy – As part of their overall responsibilities, the Board of Directors decides how much cash the company they oversee will return to shareholders in the form of dividends. Some companies pursue a target dividend every year despite what may be going on operationally or in their respective industries. While some companies pay out the exact same dividend every year no matter what, others pay a fixed percentage of firm earnings whatever they might be. Each company is unique so it is important to understand what their dividend payout policy is as you pursue your own financial goals It may also help to research the dividend payout policies of other companies in the same industry to put your researched figures in context.
Reinvesting Your Dividends
Companies have two ways of handling dividends. They can send dividend distributions directly to investors, or reinvest the dividends to purchase additional company shares. By reinvesting their dividends an investor may realize higher returns than they would have otherwise. Generally, investors can opt into their preferred option for handling dividends during the brokerage account opening process and can change their preferences at any time. When an account holder chooses to reinvest their dividends in stock, they do not incur a trading cost to obtain the additional shares of stock. More importantly, they benefit from the power of compounding.
Compound return is the cumulative effect a series of gains have on the original capital invested over time. In our first example, let’s assume the investor does not take advantage of compounding. If the investor purchased $100,000 of stock in 2018 and received a 10% dividend yield, it would equate to a $10,000 dividend. For the purpose of this example, let’s assume the investor opts to receive the $10,000 dividend in cash that same year, and that the stock price did not move up or down in value. They are right back to their original $100,000 invested. If the investor receives another 10% or $10,000 dividend in 2019, their total return over the two-year period is $20,000 ($10,000 in 2018 and $10,000 in 2019).
Now let’s assume the same investor decides to reinvest their dividends. In 2018, the 10% dividend yield or $10,000 would be added to their original $100,000 balance to equal $110,000. In 2019, the same 10% dividend yield would be calculated off $110,000 worth of company stock instead of $100,000, meaning the investor’s total return would be $21,000 at the end of two years ($10,000 in 2018 and $11,000 in 2019). Just by reinvesting their dividends, the investor earned an additional $1,000. When viewed over a longer period of time, the power of compounding becomes increasingly attractive.
Investing in Dividend Stocks Through ETFs
Another smart way to invest in dividend-paying stocks is through ETF’s, or exchange-traded funds. A number of ETF’s focus on assembling just dividend-paying stocks; often anywhere between 50 and several hundred companies diversified across industries. As part of their mandate, they collect the dividends paid out by the underlying stocks in the ETF and distribute them to shareholders of the ETF. Since ETFs are made up of a portfolio of stocks that typically pay out quarterly, some can be structured in a way to pay out dividends on a monthly basis (check the ETF’s prospectus for the payout frequency of dividends). In terms of tax treatment, ETF’s are often favored over mutual funds given their ability to control the amount and timing of income tax to the investor. A downside of investing in ETF’s concentrated in dividend-paying stocks is that you have less control over the individual stocks contained in the ETF, meaning there are some you may not have purchased if you had researched the companies yourself.
*If you want to get started incorporating dividend-paying stocks into your investment portfolio, talk with Mink Wealth today! We can help you understand and clarify your financial goals, plus provide a complimentary review of your investment portfolio