“How many millionaires do you know who have become wealthy by investing in savings accounts? I rest my case.”
— Robert G. Allen
There are a lot of misconceptions when it comes to investing in the stock market. Investing is the same as trading or gambling, or it is a get-rich-quick scheme – to name a few. Not only are these misleading, but they also lead people away from the most effective way of growing your money. Investing – in a nutshell – is a proven way to build wealth over a long period of time. There’s data that goes back decades that proves this. Consider this for example; if you had invested $8,000 in the S&P 500 index in 1980, your investment would be nominally worth approximately $783,086.76 in 2021.
So let’s break it down.
There are two ways you can make money in the stock market – capital appreciation and dividends. In simpler terms, the first way to make money is where you sell stock shares more than you bought them for. For example, you buy Apple stock at $50 a share, and sell when the share price hits $120 a share, and pocket the difference.
The second way to make money is through dividends. A dividend is a cash payout by the company to its shareholders. A portion of a company’s earnings is distributed to shareholders in the form of dividends as a token of appreciation for investing in the company. The payouts are made at frequent intervals – usually annually or quarterly, although there are some stocks that pay a monthly dividend. So you invest in dividend stocks and get paid frequently.
Keep in mind that, apart from cash dividends, there are other types of dividends such as stock dividends, property dividends, etc. However, within the scope of this article, we’ll be only discussing cash dividends.
Dividends are a great way to generate passive income, as there’s virtually no effort involved in earning dividends. Hence, investors often look for stocks that pay dividends, in order to generate returns on top of the capital gains from the stock. This strategy is referred to as dividend investing.
Let’s dive deeper into it.
What is dividend investing?
As I said, investors buy dividend-paying stocks to increase their profits, generate passive income or compound their returns over time. Investing in dividend-paying stocks allows investors to generate cash from their stocks, at virtually no extra cost or effort. Also, dividend stocks act as a hedge against market volatility. The reason is, whether it’s a bull or bear market, dividend-paying stocks will ensure returns for your portfolio. Especially in a bear market, when you see your investments lose value, it’s good to have a consistent income that can alleviate the impact.
However, bear in mind that not all stocks pay a dividend. Instead of paying shareholders, the company might reinvest earnings into R&D, expansion, or acquiring businesses. And that can drive up the price – which ultimately benefits the shareholders. Whether or not to pay dividends is determined by the board of directors. For instance, Amazon has never paid a dividend, and perhaps they never will. Despite that, the stock has produced returns of 193,521.39%. So not paying a dividend alone, does not make it a bad investment.
Whether it’s retirement planning, long-term wealth creation, or whatever the goal may be, dividend stocks are an integral part of every investor’s portfolio.
Look for these criteria in dividend stocks
Now you know what dividend stock investing is. Let’s take a look at how you can find the best dividend stocks for your investment portfolio.
When it comes to selecting stocks that pay dividends these are some metrics to look at:
Dividend yields are the first metric investors look at when assessing potential dividend stocks. It is the annualized dividend, expressed as a percentage of the stock price. So if a company pays a total dividend of $5 a share and the share price is $100, the dividend yield is 5%. The higher the dividend yield the more you get in dividends.
But there’s a catch here.
High dividend yields are not always ideal. Because you see, when calculating the dividend yield, the dividend that was paid in the previous year is taken into consideration. So a decline in stock price will result in a higher dividend yield. Novice investors might see this as a great dividend-paying stock when actually it isn’t.
So investors should ideally look at more metrics to get a clearer picture of the company.
The dividend payout ratio or simply – payout ratio – is a measure of how much of a company’s earnings are distributed to shareholders as dividends, in a year. It is calculated by dividend paid divided by net income and expressed in percentage. For instance, if Apple pays 24% of its net income in dividends, then Apple’s payout ratio is 24%. It can also be calculated by dividing dividend per share by earnings per share (EPS).
The idea is to find companies that have a high yield but only pay out a sustainable portion of their income. For example, Apple only pays out 24% of its net income.
As for an ideal ratio, consider investing in companies that pay not more than 55% of their net income. This makes sure that they can keep paying dividends consistently without having to compromise reinvestments in the business.
How to find the best dividend-paying stocks
The first step is to identify great dividend stocks.
Select dividend stocks
There are a couple of ways to go about this. The easiest way is to start with a stock screener. Most online brokers have inbuilt stock screeners that are based on different investment strategies. You can find the dividend screener there.
Once you have a list of potential stocks for your dividend investing strategy, it’s time to do a deep analysis of each stock.
Look for the payout ratio
Now that you know about dividend yields and payout ratios, it’s time to put them to use. I have already explained why looking only at dividend yield can trick you into investing in yield traps. So ideally you should look at the payout ratio when evaluating stocks. Remember, you are looking for a good payout ratio, at the same time you want it to be sustainable. Meaning, you don’t want the payout ratio to be too high or too low.
It mostly depends on the industry and the company. If it’s a large company and it is in an industry where you don’t need to invest large amounts of money into R&D, or capital expenditures, it makes sense to pay out a significant amount of your earnings to shareholders. Coca-Cola is an example of this.
Whereas it does not make sense for a biotech company to pay out a substantial amount of its earnings since a biotech company needs huge investments in R&D, capital expenditures, etc. to succeed in the industry.
So ideally you should look for a payout ratio between 1% to 35% for a mature company. Mature companies are the ones that dominate their respective industries. Coca-Cola, P&G, Johnson, and Johnson are some examples. Certainly, there are exceptions. Coca-Cola pays out 73% of its earnings as dividends since they have a superior cash flow.
The point is, it’s a little tricky to narrow it down to a specific number when it comes to the payout ratio. As a rule of thumb, you should stick to companies that pay no more than 55% of their earnings.
Dividend growth and past payouts
Another aspect to consider is how well the company has paid out dividends in the past. Have they been consistent with dividend payouts? More importantly, have they been consistently increasing their dividend payouts? Because there are companies that pay a dividend only when they have a good year. Sometimes, companies make a one-time dividend payment. On the other hand, growing companies might cut dividends now and then to expand their operations. So it’s quite important to look at how well the company has paid dividends in the past. Even though past performance does not guarantee future results, it gives you an impression of where the company is heading.
If a company has been consistently paying dividends and has also been increasing payouts, you are looking at a healthy company with good earnings growth and a potential dividend stock for your portfolio. AT&T is an example of this. Not only has it paid dividends consistently, but it has also been increasing payouts since 1987. Currently, AT&T yields 7.15%.
Some companies have been increasing their dividend payouts consistently for over 50 years. These companies are known as the Dividend Kings. P&G, Coca-Cola, and 3M are examples of Dividend kings. Then some companies have been doing this for 25 consecutive years, they are known as Dividend Aristocrats. McDonald’s, Kimberly-Clark, and Realty Income are some examples. There’s also Dividend Achievers who have increased their payouts for the last 10 years. Microsoft, Visa, and Nike are examples of Dividend Achievers.
Bottom line – focus on the combination of payout ratio and past dividend appreciation – growth and consistency are what we’re looking for. It should tell you how healthy the business is, and how likely it will continue to pay and increase its dividends.
Here’s something to help you;
Dividend growth investing is a popular strategy when it comes to growing your money. But we have barely touched upon the most important aspects. To understand more about how a combination of capital gains and dividend income can grow your money exponentially, check out our guide to Dividend Growth Investing. This will give you a head start with your dividend investment strategy, and much more.
Frequently asked questions
How do I start investing in dividends?
You can start by selecting a dividend stock using the metrics we discussed above. Once you buy the stock, you’ll be notified when the dividends are distributed to the shareholders. Note that the brokerage may deposit the cash from dividend, directly to your bank account. Some brokers allow you to reinvest those dividends. Check with your brokerage to know more.
Are dividends good for beginners?
Yes, dividends are good for beginner investors. Dividend stocks allow you to generate a return on your investment, with less due diligence. You can start with Dividend Kings, Dividend Aristocrats, or Dividend Achievers.