When traders and investors look to profit in the markets, they often look to stocks that they believe will grow rapidly in price. However, there is another group of stocks that can not only offer growth potential, but a steady stream of income in almost any market condition. This group is dividend paying stocks. Let’s examine what a dividend is, how it can benefit you financially, and how to choose the correct securities for your portfolio. Additionally, we can explore methods for protecting these investments in market turndowns.
What are Dividend Stocks?
A dividend is nothing more than a share of the profits of a company. When you purchase shares of stock, you are buying a piece of ownership in that company. Through the company’s normal operations, it may make a profit. Sometimes, instead of reinvesting all the profit back into the company, the company shares the money with its owners. As a shareholder, you are an owner and entitled to your portion, called a dividend, if you meet certain criteria. So, a dividend stock is a stock that pays owners a dividend, or a share of the company’s profits on a regular basis, usually quarterly although this can vary.
Companies that offer dividend stock are usually larger, well established companies with predictable profits. Other securities that trade like stocks such as Exchange Traded Funds (ETF’s), Real Estate Investment Trusts, (REIT’s), and Master Limited Partnerships, (MLP’s) may also pay shareholders dividends.
How Dividends Work
There are rules that dictate how dividends are paid and to whom. Those who own dividend stocks or wish to, need to be aware of what these rules are and the corresponding dates in order to properly invest in dividend stocks.
Important Dates for Dividend Earning Stocks:
- Announcement Date:
This is the date when the company’s management announces that there will be a dividend and the amount of said dividend. There are no monies paid on this date. All the other dates regarding the dividend will be made public at this time.
- Ex-Dividend Date:
Also known as the Ex-Div Date. This is the last day of eligibility for receiving the dividend. To receive the dividend as a shareholder, you must own the stock BEFORE this day. If you buy the stock on or after the ex-div date, you will not receive the dividend as it is said to now be trading ex-div (excluding the dividend).
- Record Date:
This is when the company officially records who will receive the dividend.
- Payment Date:
This is the time when the company issues the payments of the dividends and monies are credited to the shareholders’ accounts.
Why Buy Dividend Stocks
There are numerous advantages to buying dividend stocks. The most obvious one is that in addition to price appreciation, the investor is offered an additional source of income from the dividend. In addition, depending on tax status and location, investors may have a lower tax rate on dividend income. Consult a tax professional for more information.
Another advantage is that since dividend stocks are mainly offered by larger, more established companies, their share price is more stable. They are less likely to crash, although they still can. And their profitability is likely to continue. Lastly, by combining the use of simple options strategies on these dividend stocks, it may be possible to maximize returns and protect a portfolio against market turns.
How to Buy Dividend Stocks
Buying a dividend stock is no different than purchasing any other type of stock. If you purchase the shares before the Ex-div date in your brokerage account, you should receive the dividend when paid. Be aware that when the stock goes ex-div, it is likely to gap down in price by the amount of the dividend to be paid. This is normal since whomever purchases the stock ex-div is not receiving the dividend and the value of the stock should decrease by that amount. The price will usually recover before the next dividend is paid. Prior to purchasing a dividend stock, investors should check to ensure that the dividend is stable.
Make a Profit Assessment
Remember, the dividend is a portion of the company’s profits from operation. This means that the company needs to have stable profits on an ongoing basis. Earnings disappointments are no good as it could affect the dividend being paid. Investors might want to look for companies that have long term (5-7 years) earnings growth expectations of 5 to 15%. It may be enticing to look for more growth, but those expectations could be unrealistic.
Check the Company’s Cash Flow
Investors are receiving cash from the company; therefore, the company should have good cash flow to pay for those dividends. Additionally, the company should not be shouldered with high debt. A suggested debt to equity ratio would ideally be 1.0 or less. The more cash a company has, the more likely it is to share it!
What is the Payout Ratio?
The payout ratio is also a factor to examine. How much of the profits is the company paying to its shareholders in the form of dividends? If the company earns $2.00 and pays a dividend of $1.00, it has a payout ratio of 50%. Too high of a payout ratio means that the company is trying to make shareholders happy and may be sacrificing growth. Worse yet, if the ratio is over 100%, the company may be borrowing to pay the dividend. Either way, that is not a sustainable model and could mean the dividend gets lowered or removed altogether in the future.
To avoid this, one might look for companies with a payout ratio of around 40%. This is considered by many to be a sustainable, yet fair level. This ratio alone should not be a deciding factor. Compare the company’s payout ratio to others in its industry to see if it is too high or too low.
There is a group of stocks called the Dividend Aristocrats. These companies make the list because they are members of the S&P 500 and have increased their dividends every year for the past 25 years. While this is no indication that they will continue, this historical track record makes them very attractive to investors looking to profit from dividends.
If a company has a history of paying out dividends but suddenly announces a cut in the amount of that dividend, it is usually a sign that the company is in trouble.
Previously mentioned were the dividends from REITs, MLPs, and ETFs. Dividends for these products are not calculated in the same way as dividends for stocks. Stock dividends come from company profits. Fund dividends may come from dividends received in stocks being held by the fund, bond coupons held in the fund or from the fund’s Net Asset Value (NAV).
There are obviously many things to be aware of in order to invest or trade dividend stocks properly. Be sure to educate yourself fully before diving into them.
Brandon Wendell can be contacted on this link: Brandon Wendell