Dividend investing is an investment strategy that involves purchasing stocks that issue dividends. The basic idea behind this is that you’re not just relying on capital gains (your stake in the company increasing in value), but you get a steady flow of income from the dividends.
Each quarter, on the pre-agreed date of dividend declaration, a company’s board of directors will declare how much in dividends will be distributed to the shareholders. As a shareholder, you must already own the stock on the dividend record date.
Of course, not all dividends are the same. If you own more stocks, you get a higher share of the dividend payout. If you’ve invested in a second company, they may pay more or less dividends depending on a few different factors.
Sometimes firms will keep their dividends in line with a certain payout ratio and dividend yield, but it can change. In particular, the dividend yield is prone to change. These are the two most important KPIs/ratios that investors are concerned with.
Dividend yield = Annual Dividend / Current Stock Price
The reason why this changes often is because both of the inputs are prone to change. Stock prices fluctuate constantly, meanwhile dividends often depend on the amount of profit the company makes.
Payout ratio = Dividends per share (DPS) / Earnings per share (EPS)
As you may have guessed already, the payout ratio is essentially how much dividends they pay to shareholders out of the retained earnings. Thus, a 50% payout ratio indicates that it gives half of its retained earnings to its shareholders.
The payout ratio tells us about the company’s attitudes, strategy and so on. A low payout ratio may indicate that it is looking to grow quickly, so it’s reinvesting most of its money. This is useful information, but it doesn’t necessarily tell us the direct return on our money like the dividend yield does.
Is dividend investing less risky than regular, non-dividend stocks?
Whilst there is no absolute answer here, there are certainly many reasons pointing to this being true. Generally speaking, companies more often than not try and not to reduce their dividends just because profits have dropped. You can find companies that have upheld their dividend payouts to the same level for years and years.
There is an element of risk involving any form of equity. Owning dividend-paying stocks doesn’t mitigate this, but it may mitigate it a little. If you consider an economic crisis, your company’s value will likely decrease regardless of whether it pays dividends or not. However, if your shares are now worth half as much, technically your dividend yield will have doubled, assuming they continue paying the same amount of dividends.
Whilst this is a “perfect” example, the logic is strong. If you can continue receiving income from a company’s stock that is falling, then this is the silver lining that you do not get with non-dividend paying stocks.
Generally speaking, a company’s dividend track record can tell you a lot about the safety of your investment. If the company is paying dividends for years, it’s often the case that they have higher earning than non-dividend stocks. At the end of the day, companies can get as creative as they want when it comes to accounting, but you can’t hide away from paying dividends. It’s a lot of money that you’re paying out, and it reflects well on the trustworthiness of your company accounts.
Lastly, it is often argued that management is slightly more disciplined when stocks are dividend-paying. One of the disadvantages of going public is that the company becomes a bit of a servant to the shareholders. Suddenly everything becomes more about the bottom line. This is even more true for dividend stocks, who have to impose even more discipline to make dividend payments.
What’s a good dividend in the USA?
The average dividend yield of the S&P 500 is 2%. Anything 1%+ above this average (3%) is considered good by most investors. However, you can’t invest based solely on this, as there’s a lot of fundamental analysis to also perform.
Furthermore, a 3% dividend yield by company A may sound decent, but company B’s 5% sounds even better. However, if company A is only paying out 20% of their stable earnings, this is considerably more impressive than company B who may be paying out 100% of its earnings.
In short, company B is at its maximum short-term potential, whereas company A is cruising along as a very profitable company that has a lot of room to increase its dividends and possibly its company’s value.
Should I invest directly in dividend stocks or via ETF?
ETF stands for Exchange Traded Fund. ETFs are publicly traded funds that tracks an index, and you can even get dividend ETFs – these are essentially a basket of high-paying dividend stocks. Letting someone else (a group of experts) handpick a basket of diversified dividend stocks for you, meaning you can put your feet up instead of being in control sounds great for many investors. However, there are of course pros and cons to each.
Why you may opt for a dividend ETF
- Time saver – dividend ETFs can save you a bunch of time from researching companies and performing analysis. ETFs already have a basket of stocks, meaning that the responsibility is no longer on you to invest. The single purchase of an ETF is significantly faster.
- Stress and risk – of course, this will likely result in a much more diversified portfolio. ETFs usually have a lot of different company stocks, meaning there’s less risk upon a market crash. You’re not putting all of your eggs in one basket, so to speak.
- Passive – dividend ETFs, managed by someone else, are a much more passive form of investing
- Low fees – ETFs offer extremely low fees as low as 0.05% each year
Why you may opt for direct dividend investing
- Hand-picking – if you already have specific companies you want to invest in, direct investment may be necessary. The upside of this is that you can create your portfolio exactly how you want it, which afterall, could outperform the ETF.
- No bad picks – When you have dividend ETFs with over 400 companies like Vanguard, it’s unlikely that you’re not going to get lumbered with some companies that fail to pay out. The high amount of shares in an ETF can often decrease the average quality of investments, leading to more less predictability. Direct investing can often give you less unpredictability.
- No on-going fees – you only incur a fee when you buy or sell the dividend stocks. This means you pay fees two times per stock. ETFs on the other hand charge you an annual fee, which could hit the long-term returns much more. These on-going ETF fees are more of a problem for investors with a large portfolio, who could lose thousands per year.
Should you invest in dividend stocks abroad?
Looking abroad to countries such as Canada can be a great way to find more investment opportunities. Having more investments to choose from can only be a good thing. Furthermore, if your home country’s economy collapses, there will be less damage if some of your investments are abroad, because these other markets may not be struggling as much.
If you’re looking to say, Canada, for dividend investments, then you should take differences in taxation, fees, tax credits and changes in exchange rate into consideration. Your foreign investments may have some currency risk, although having a diversified portfolio can help reduce this risk.
Foreign markets can often be less saturated, meaning that good investments aren’t snapped up quite as quickly.
Dividend investing strategy for beginners
There is no real shortcut to finding the right companies to invest in. It requires some time to research, compare and perform some analysis. This process can be standardized though and somewhat automated a little if you know-how.
Firstly, you want to get to grips with the key metrics. Some of the most important ones are:
- Dividend yield
- Payout ratio
- Cash payout ratio
- Total return
- P/E ratio
It’s important that there’s not too much focus on dividend yield. Using that alone could cause some problems, as a high yield can often be as a result of the stock price dropping due to an expected dividend cut.
The payout ratios should be used to measure how sustainable the dividends are (avoid companies that are throwing all of their retained earnings at shareholders).
You should also read the news and understand the market itself. There may be new laws being introduced, commodity price changes, political instability and many more influencing factors. Ultimately, you want to avoid volatility.
Once you’ve picked your company, the dividend reinvestment plan is a pragmatic long-term strategy (often referred to as the Drip). This means that everything earned from dividends if reinvested back into the shares at the company, which is commission-free. This lets the magic of compounding take the course, but may not be ideal for those looking for immediate cash flow.
10 Dividend stocks and ETFs which are considered staples
- Nestle – NSRGY
- Market Cap: $318.5 billion
- Dividend Yield: 2.5%
- Payout ratio: 78.5%
- Bristol-Myers Squibb Company – BMY
- Market Cap: $156.4 billion
- Dividend Yield: 2.70%
- Payout ratio: 47%
- Unilever – UL
- Market Cap: $145.5 billion
- Dividend Yield: 3.22%
- Payout ratio: 45%
- AT&T – T
- Market Cap: $280 billion
- Dividend Yield: 5.5%
- Payout ratio: 91%
- Discover Financial Services:
- Market Cap: $26 billion
- Dividend Yield: 2.1%
- Payout ratio: 19%
- McDonald’s Corp
- Market Cap: $156 billion
- Dividend Yield: 2.4%
- Payout ratio: 60%
- JPMorgan Chase- JPM
- Market Cap: $433.4 billion
- Dividend Yield: 2.6%
- Payout ratio: 32%
- Texas Instruments – TXN
- Market Cap: $123.1 billion
- Dividend Yield: 2.73%
- Payout ratio: 56%
- Home Depot – HD
- Market Cap: $253 billion
- Dividend Yield: 2.34%
- Payout ratio: 54%
- Maxim Integrated Products – MXIM
- Market Cap: $16.6 billion
- Dividend Yield: 3.13%
- Payout ratio: 67%