This is a post on the basics of dividends and what to look for when investing for dividends. Investing always requires careful study and due diligence of the investment before purchasing it, dividend investing has its unique challenges.
What are Dividends?
Dividends are the profits distributed to shareholders by the corporation, when a company decides to share part of its profits with the shareholders this is called the dividend. When a company has a profit it can either choose to reinvest that into the company to grow it or it can choose to distribute this to shareholders. When a company is established and has a strong cashflow they will start distributing dividends, you will not find many start-up companies paying dividends.
Each company has a dividend policy in which they outline what percent of the profits will be distributed to shareholders, usually the numbers are between 15-50% depending on the strength of the company. Usually dividends are paid out quarterly, but they could also be paid out monthly or semi-annually.
What is Yield?
Yield is your dividends divided by your stock price, if your dividend is $0.50/year and your stock price is $15/stock your yield will be 0.5/15= 3.33%. That is the return you are getting on your money without accounting for stock gains and losses. Ones you have purchased a stock at a certain price, your yield is locked at that price, unless dividend payout is changed or you purchase more stocks at different prices.
Things to watch out for when investing for dividends
Dividend investing has its own unique risks, investors who buy dividend stock usually buy it for the dividend and if there is a change in the payout this will affect the stock price so it is important to watch out for a few things when investing for dividends.
1. The Payout ratio
Payout ratio is the percentage of profits that is paid to investors as dividends. The higher the ratio, the higher the potential risk for dividend cuts during economic slowdown. If a company pays out 85% of its profits and following year profits drop, due to slowdown or higher costs, by 10% the payout ratio will be 95% very high! On the other hand if a company pays out about 40%-50% of profits there is a lot more room for profit drops. So watch out for high payout ratio, I personally do not like anything above 65%.
2. Dividend History
Has the company been paying out dividends for a long time? This shows the strength and willingness of the company to share profits consistently with shareholders. Has the company raised its dividends consistently? A good source for that information is the S&P Dividend Aristocrats, a list of dividend paying companies who have raised dividends at least for 25 years.
3. Debt Ratio
Why is debt ratio important to dividend investors? Debt ratio is the measure of the company’s liquidity, since bond holders are ahead of equity holders it is important to know how much debt the company has. If the debt ratio is too high the dividends will be in danger if company’s earnings take a fall, since they have to be paid before shareholders. A common Debt ratio is simply Total Debt/Total assets the higher the number the more risk you take.
Besides your regular due diligence when choosing investments, I think these are probably the top three factors to look at when looking to invest for dividends.
Top 5 tips for dividend investors:
1. Look for companies with long track record of increasing dividends, S&P Aristocrats
3. Pay attention to Payout ratio, over 65% is too high
4. Reinvest your dividends
5. Hold Dividend paying stocks outside of Registered Plans to benefit from the dividend tax credit
Remember: Past performance is no guarantee for future performance and dividends can be increased, decreased or eliminated at anytime without notice.
Do you have any tips for dividend investors?
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