Tips for Investing in Stocks with High Dividends
Why Consisder Dividend Stocks?
In today’s low interest rate environment, investors need somewhere to put their money to see it grow. Stocks that pay a substantial dividend can lead to a long-term growth in value. Typically, companies that pay a dividend are mature companies that make money year after year and return part of the profit back to the shareholders in form of a dividend.
Dividends are a part of a company’s quarterly or yearly earnings that are given out to a certain type of shareholder. The amount of dividends given out by a company is determined by the board of directors. These dividends usually come in the form of cash, stock shares or other investment properties.
Companies have a number of choices when they post a profit for the quarter or year. They can either keep the profits in the bank in the form of retained earnings, which is often the case for a newer company that is still establishing itself. A company also has the choice of investing the money in expansion projects, marketing or other departments. The third option is to give them out to shareholders as dividends.
Some companies also engage in share buybacks through their net profits, which is a method of buying their own stock from the open market. However, these share buybacks do not alter the company’s stock value in the same way prices rise or fall when independent investors buy or sell company stock.
It is not only major companies that pay dividends on stocks, but also mutual funds and Exchange Traded Funds (ETFs). If an investor or organization owns stocks in a mutual fund or ETF, they are paid dividends when the fund shows a profit.
With mutual funds and ETFs, it is also possible for shareholders and investors to receive a capitals gain distribution. This type of dividend comes from situations where a fund manager liquidates certain profitable stocks and securities in their mutual fund. The profit from this liquidation is split among the shareholders of the mutual fund or ETF.
Video on Dividend Stocks
Some of the terms to be familiar with:
Before you consider putting your hard earned money on the line in the stock market, there are few basic terms that will help guide you through this journey.
Declaration Date –
In reference to dividends, the declaration date is a set date where the payment of dividends is announced by the board of directors of a company. On the declaration date, the board of directors release a statement that refers to the declaration date, the size of the dividend, the record date, the ex-dividend date and the date of payment.
If we look at it as a timeline, the declaration date of a company may be the first of the month. In this case, they will set a record date and an ex-dividend date.
Date of Record –
The record date is the day when the company goes through their electronic records and makes a list of the shareholders who are owed dividends. This is usually a few days to a week after the declaration date.
The ex-dividend date is always three days before the record date, and this is the last day where investors may buy shares in the company and still remain eligible for dividends from that quarter or year. For example, a company declares their intention to provide dividends to shareholders on the 1st of May. In this case, the record date is set as the 5th of May. Investors would then have until the 2nd of May to purchase shares and receive dividends on those shares. Anyone who purchases shares after the 2nd of May would not receive dividends for that period.
The reason investors must buy their stocks three days before the ex-record date is because it takes that amount of time for all the paperwork and behind-the-scenes work of a stock purchase to be completed. An individual is not formally recognized as the owner of stock until three days after their purchase.
Payment Date –
The payment date for dividends is usually a week or ten days after the ex-record date.
Compound Interest –
In general terms, compound interest refers to the practice of calculating interest on the principal balance along with the accumulated interest of all the previous periods. A simple formula is used to calculate compound interest for investments:
[P * (1 + i)n ]- P , with P referring to the principal amount at present, i referring to the nominal interest rate and n referring to the number of periods.
For an example, we can take a principal amount of $1000, an interest rate of 10 percent and a period of ten years – with the interest compounded on an annual basis. At the end of the ten-year period, the compound interest is $1593.
To properly understand the impact of compound interest, we can identify what an investor would earn over ten years with the same interest rate, through a regular investment. In this case, they would earn $1000 in interest over ten years at the 10% rate. The greater the starting amount, the more an investor can earn through compound interest.
Compound Interest and Dividends –
For investors who regularly invest in companies that offer dividends, there is also the possibility of reinvesting this dividend money back into the market. In a sense, the investor is compounding their earnings because they are making a lot more money through this reinvestment then they would by taking the dividend money and putting it in a checking or savings account.
To understand the impact of compounding on dividend profits, let us use an example where someone invests $20,000 in a stock that offers dividends. This stock offers a 12 percent annual return. If someone kept reinvesting the money they earned from dividends into the same dividend-offering stock at that annual return rate for 30 years, they would have $599,199.
In comparison, if the investor in our example only invested the original $20,000 in the dividend stock, and kept depositing the yearly dividends in a checking or savings account with next to no interest, they would only end up with $72,000 in dividend payments over 30 years, plus the original $20,000 in the company stock.
Of course, there are risks with compound investment because you are continuously putting that money back in the stock market. There is the risk of a profitable and reputable company going through a bad spell where their stock value tanks. In this case, the investor would not only stop receiving dividends, but they would lose some of their money when the stock’s value declines. This is why investing in dividend-paying stocks is a skill that investors must master if they want to achieve long term success.
DRIP Program –
The DRIP, or Dividend Reinvestment Plans, Program is a way for shareholders to buy stocks directly from a company, instead of having to go through brokerages and their commissions. This is done through the money gained from cash dividends, which the company takes themselves and uses to purchase the investor more shares, or a percentage of shares, in the company.
This is a great way for investors to not only use the compounding interest principle to increase their returns, but also to avoid the fees and commission associated with a brokerage. Most companies that offer DRIP Programs do not charge anything for the service.
Some programs even allow investors to make an OCP, or optional cash payment, in order to purchase more shares. These payments can range from $25 to $100, depending on how many shares the individual wants to purchase. Aside from reinvesting money earned through dividends, DRIP Programs are also a great way for investors to increase their stake in a “blue chip” company without having to go through brokerages or mutual funds.
Dividend Rate –
The dividend rate is a way to calculate all the annualized dividend payments an investor receives from the stock, fund or portfolio that they own. This includes regular dividend payments along with any non-recurring payments during that period. The dividend rate is expressed through the following simple formula:
Dividend Rate = (Recurring Dividend) * (Number of Dividend Periods in the Year) + Non-Recurring Dividends
Some companies have fixed dividend rates over a period of a few years, while others have adjustable rates. We can look at an example where a company pays a $5 dividend on a quarterly basis, along with a bonus dividend of $1 per share because of a particularly profitable event that they did not expect.
In this case, the Dividend Rate = ($1) * (4) + $5 = $9
Dividend Yield –
The dividend yield is a way for investors to understand how much money a company is paying out to their investors in relation to their share price. The dividend yield is a percentage value and it is calculated by dividing the annual dividends per share by the price per share. This is a great way for investors to understand the “bang for their buck” of each stock investment they are making.
We can use a real world example to understand dividend yield:
Microsoft had their most recent dividend payout at $1.44 per share. At the time, their share price was around $54.34. This means the dividend yield on Microsoft stock was at 2.65%. This is a fairly common number for larger, stable companies. While they do pay out dividends on stocks on a regular basis, they do not pay a huge amount. This is because the focus of these companies is on improving their brand, investing in new technologies and providing their investors greater value through gradual increases in the share price.
Payout Ratio –
The payout ratio is a way to define what percent of a company’s earnings are going to their stockholders through dividends. The payout ratio is calculated by dividing the dividends per share by the earnings per share. For example, a company that offers $5 in dividends per share and earns $20 per share will have a payout ratio of 0.25 or 25 percent.
High Dividend Yield Stocks
There are some investors who seek sharp increases in their investment money by putting their money in high dividend yield stocks. There are some stocks out there that offer substantial dividends, with some having a payout ratio of greater than 0.50 or 50 percent. However, these stocks and equities are typically very risky, for the simple reason that they are giving up too much of their money to investors through dividends.
Companies such as Microsoft and Apple do pay dividends, but a bad couple of quarters will not destroy their entire business. This is because they keep a large chunk of their money within the company to offset against such risks. In contrast, a company or fund that pays out more than half their profits as dividends to investors has much less wiggle room. If something goes wrong for this company, they are in a tough spot. This is why investors must think very carefully before investing in companies that have such a high rate of paying out dividends.
Despite the risks, there are many successful companies that have been paying dividends to their investors for years, while maintaining a payout ratio of between 0.35 to 0.55. For example, Verizon had a 51 percent payout ratio in the past year, while General Motors reached 55 percent.
Stock Analysis: Verizon Communications Inc. (Stock symbol VZ)
In terms of their revenue, earnings per share and dividend payouts, Verizon Communications is one of the best stocks an investor can choose. The company boasts a very high, consistent and gradually increasing yearly revenue. They also offer stable dividends:
Their earnings per share for the same years was $4.37, $2.42, $4, $0.31 and $0.85 respectively. This means that Verizon is committed to paying their investors increasing dividends, even if the company happens to have a disappointing year.
The reason they can get away with this behavior is because of the massive revenue they earn on an annual basis, along with the stability of their field. While other companies can suffer after bad years, Verizon has such a significant role in many different communications fields that their staying power is not in doubt.
In terms of their payout ratio, Verizon sits at 0.51, 0.89, 0.52, 6.55 and 2.32 for the past five years. Their P/E ratio hovered between 30 to 40 in 2011 and 2012. The Verizon P/E ratio climbed sharply in the first two quarters of 2013, because of their relatively poor earnings in 2011 and 2012. Since the start of 2014, it has hovered between 10 to 20.
Keep in mind, the P/E ratio is a calculation of the price per share divided by the earnings per share from the last four quarters. This means that the P/E ratio of a company on January 2016 reflects the previous four quarters’ worth of data. Companies that have a high price/earnings ratio are showcasing a high stock price despite their relatively modest earnings per share.
If a company has a high P/E ratio, it means that investors believe they are going to experience substantial growth in the coming years. In the case of Verizon Communications, it appears that investors were correct. Their earnings per share rose significantly in 2013 and 2015.
Stock Types for Dividends
Whenever investors are asked about the types of stocks that pay out the most dividends on a consistent basis, they will point you to companies in the telecommunications and utilities sectors. On average, telecommunications companies offer 5 percent yields and utilities offer 3.5 percent. A stock’s yield refers to the income generated from the investment.
Keep in mind, the companies that pay the most dividends on a consistent basis are not always the companies that have the highest percentage increases in dividend payments from one year to another. This is because these companies, which are usually in the telecoms and utilities sectors, prefer to remain consistent with their long term vision for the company and with their dividend payments.
As noted with the example of Verizon Wireless, consistently increasing dividend payments are expected from these companies. However, it is rare to see dividend percentage increases of 20 or 30 percent from the telecoms or utilities industry. Those jumps are more often found in consumer discretionary or financials stocks. They offer the best percentage increase from one year to another, but those companies are also unpredictable in terms of their stock price. A great two years may be followed by a very bad one for investors, which makes them a tougher sell as long term investments.
When considering stock types for dividends, look to consumer staples as a good indicator for larger companies that will always remain on solid footing regardless of how the economy is performing. Consumer staples are goods that people are not willing to eliminate from their budget, regardless of how much money they are making. Companies such as Procter & Gamble or Phillip Morris are in the business of consumer staples.
Investors who want serious value for their money when it comes to dividends can also analyze the list of Dividend Aristocrats. This list refers to companies that have provided their shareholders with increasing dividends for the past 25 years. Companies such as Walgreens Boots Alliance, Questar Corp, McDonald’s, and Wal-Mart Stores make up this list.
Good Book on Dividend Stocks
Importance of Diversification
The idea behind diversification with respect to stock investments is to lower the risk for an investor. After all, the goal of investing is to gain substantial returns while limiting a person’s risk in the event of a particular company or industry suffering from a bad spell.
It is impossible to give investors a guarantee that their portfolio will never see losses. No matter how much a person diversifies, they cannot 100 percent protect against risk. However, a vast majority of Wall Street experts believe that the best way to minimize risk while investing in the long-term is through diversification.
When discussing diversification, we must first look at the types of risk associated with stock investments. Risks are generally divided in two categories: undiversifiable and diversifiable.
As the words suggest, undiversifiable risk refers to a system-wide risk that may involve all companies in the market. For example, a change in the interest rates, high inflation, a war, economic collapse and other such events can impact every single sector on the market. It is impossible for investors to diversify their stock portfolio to protect against this risk.
Now we come to diversifiable risk, which is specific to a company, industry, market sector or even a country. This is the type of risk that is mitigated through diversification.
Diversification is accomplished through buying stocks in companies within multiple market sectors, industries and countries. The idea is to have a collection of stocks where part of the portfolio cushions the blow of the other part experiencing a bad period. For example, if five of your ten investments have a bad 6 to 12 months, the other five should be performing well enough to ensure that your overall portfolio is still performing positively each year.
It is also possible to diversify by purchasing other assets, such as bonds, gold or other commodities.
Keeping Up with Companies and Market Trends
A major part of stock diversification is about keeping up with information regarding the companies in an investor’s stock portfolio. In addition, investors must pay attention to the whole market, and the industries pertaining to their stock investments. For example, an investor with investments in both Apple and Microsoft would pay particular attention to market trends that are relative to the technology industry.
By focusing on both companies and their industries as a whole, investors can try to react before the rest of the market in terms of buying and selling stock. If an investor is seeing warning signs in the market for a particular industry, they can scale back their investments in certain stocks and reinvest that money elsewhere.
Investors must also look to understand market trends and how they can impact the prices of their various stock holdings. Market trends refer to the overall behavior of the financial markets. For example, the stock markets are often quoted as being a “bull market” or a “bear market” depending on whether the market is trending up or down.
While it is very difficult to gauge market trends before they happen, investors can often understand whether a particular market is experiencing a “bubble.” For example, many investors felt that the housing market was experiencing a bubble in the years leading up to the 2008 Financial Crisis.
If an investor has stocks that are part of an industry, and they believe that industry is experiencing a bubble, they will have to think about when they should stop investing in those companies. Dropping the companies too early means losing out on potential gains from the rest of the bubble, while waiting too long means risking a financial loss because the stock prices of those companies begins to crash.
This Hub is for educational purposes only. Before buying or selling stocks or bonds, consult your financial adviser or stock broker.