When most people think of the word,” investing” ….
They usually think of stock investing. People will buy a stock, watch the share price skyrocket, cash out, and then rinse & repeat until you have accumulated enough wealth to ride off into the sunset.
What if I were to tell you there is another investing strategy where you buy and hold stocks forever and live off the interest it generates? This way you don’t ever need to touch the principal.
Welcome to the world of dividend investing.
Dividend investing is typically seen as an investing strategy for older investors looking to live off the interest, or dividends, in retirement. However, this strategy can also be used by younger investors to enjoy the fruits of their labor today as passive income while at the same time planning for the future.
Today, we are going to discuss what are dividends, why it matters, what type of companies pay dividends, how to create passive income, key metrics to find the best companies, and much more!
Let’s get started………….
What Are Dividends?
I hear this question quite often.
Simply put, dividends are a cash payment that public companies distribute to shareholders to reward them for holding their stock while the company is profitable. Essentially, the shareholders of the stock receive back some of the profit the company generates in the form of a cash payout called a dividend.
In return, this motivates the investors to keep holding onto the stock and can be a signal of the confidence they have in the company to continue generating a profit.
The amount of dividend a shareholder receives depends on the payout amount per share the board of directors sets to provides to its shareholders.
Here is an example:
You bought 100 shares of a company at a price of $10 per share, and the board of directors decided each share pays an annual dividend of $0.20. By investing $1,000 into this company, a dividend payout of $20 ($0.20 * 100 shares) would be paid to the shareholder over the course of a year’s time.
This payout amount is also known as a dividend yield and is shown as a percentage of the per share price. In the example above, the dividend yield would be 2% ($0.20 per share / $10 per share).
The dividend is distributed to shareholders in increments over the course of the year. Most companies that offer a dividend pay the dividend on a quarterly basis and some (i.e., Realty Income) pay out on a monthly basis.
Each company does not follow the same payout schedule either.
For example, Company A could pay its dividend during the year on March, June, September, and December.
Company B could pay its dividend during the year of January, April, July, and October.
To understand when dividends are paid out, there are three dates you need to understand:
- Declaration Date: The date when the company’s board of directors announces when a dividend will be paid.
- Ex-Dividend Date: You must own a dividend-paying stock by this date to receive the dividend. For example, if the ex-dividend date is April 1, then you must own stock in the company by at least 1 day prior in order to be eligible for the dividend being paid out at that time.
- Payment Date: The day dividends are paid out for a dividend-paying stock.
Why Are Dividends Important?
Because dividend investing is focused on creating a stock portfolio that pays out money or dividends. This dividend money, if structured correctly, can generate a consistent income stream. This income stream can either be benefitted from today or reinvest the money into buying more stocks or investing in other business ventures that makes more money for you and so on and so forth.
It’s making your money work for you and not the other way around. It’s truly passive income that can be used to jumpstart your financial engine. It enables the same amount of money to be exchanged multiple times all the while you grow richer and not having to work as hard to obtain better results.
Garret Gunderson coins this concept as, “The Velocity Of Money”.
To have your money be put to work for you is one of the easiest ways to generate passive income. What you do with that income is then up to you.
Plus, you can profit off the stock in 3 ways:
- Share Price Appreciation – as the stock price increases over time, you grow wealthier.
- Dividend Payments – regular cashflow coming in so long as the company pays a dividend.
- Consistency – whether the stock price goes up or down, you are paid a dividend so long as the company declares a dividend to be paid that year.
Do All Companies Pay A Dividend?
The succinct answer to that question, sadly, is no. Not all companies offer dividends.
The type of companies that offer dividends are usually established companies with a reputation for financial stability, are near the top of their industry’s growth curve (little room left to grow) and have been established for decades.
These types of companies are known as blue-chip companies. When you think of blue-chip companies, think of companies like Ford, Coca-Cola, 3M, Johnson & Johnson, etc. Another easy way to think about it is to look in the cupboards of your home at the products on your shelf. If you have been using that product since you were a kid (i.e., Tide, Kleenex, Colgate, etc.) odds-on it’s a blue-chip company.
On the flip side, not all blue-chip companies offer a dividend. A great example is the company Warren Buffet owns, Berkshire Hathaway. This company has been around for decades, and its stock price has grown steadily over time yet has NEVER offered a dividend to its shareholders. This is surprising since Warren Buffet is known to LOVE investing in companies that offer a dividend because it helps him recover his investment faster.
Dividend-paying companies also tend to be companies with good financial fundamentals and lack volatility in its stock price. Good fundamentals allow the company to control its cash supply (As I’ve said before, Cash IS King! 😊), manage its debt, and have the free cashflow to offer dividends to its shareholders. For this reason, blue chip companies tend to be safer investments than growth driven companies.
The flip side to blue chip companies, is that its stock won’t appreciate as quickly as a growth company like Amazon, Facebook, Tesla, etc. Sure, there will be some growth, but it is modest and steady. This is the trade-off for investing in a “safe” company.
Also, just because it is a blue-chip company doesn’t mean the stock price is a good deal. If you buy a dividend-paying stock at the top of the market and the price plummets, the loss on the stock price may more than offset the dividend being paid out.
The next question you may be asking yourself is, what criteria do I use to determine if it is a solid company and a good buy? We’ll look at which key metrics to investigate next.
Key Metrics To Review
There are several metrics that can be used to judge if the company’s stock price is a good buy. To simplify it for you, we’ll focus on 2 metrics.
- P/E Ratio – The price-to-earnings (P/E) ratio is calculated by dividing a company’s share price by its earnings per share. The P/E ratio is a metric that can be used to determine if a stock is fairly valued. The lower the number, the more undervalued a company is. The historical S&P 500 average P/E ratio is 15. Any company below this historical average is considered undervalued and a good buy. While this is a good metric, it isn’t the only metric to check.
- Earnings Per Share (EPS) – The EPS normalizes a company’s earnings to a per share value. The best dividend companies for that matter show the ability to regularly increase earnings per share over time and therefore raise a dividend. Plus, a history of earnings growth is often evidence of a company’s competitive advantage.
Now hold on, before you go to your brokerage account to buy that stock, you need to evaluate the health of the dividend. These metrics will help you understand how much in dividends to expect, how reliable the dividend is, and what red flags to look for.
- Dividend Yield – This metric is the annualized dividend represented as a percentage of the stock price. Dividend yield is a useful metric for comparing a stock’s current yield to its historical levels. Intuitively, the higher the yield the better…… to a point. A very high dividend yield (>6%), unless they have been able to maintain that level for several years, is a red flag that both the dividend yield and stock price may be ready to plummet. Sometimes companies will use the dividend yield to “bait” people into buying their stock in the hopes to prop up their stock price (aka dividend yield trap). Either way, this is a great metric for evaluating both the health of dividend and the company.
- Dividend Payout Ratio – This is the dividend as a percentage of a company’s earnings. For example, if a company earns $1 per share in net income and pays a $0.40 per share dividend, the payout ratio is 40%. In general, the lower the payout ratio the better since this metric shows how much buffer they have to pay a dividend in case the company’s financials worsen.
- Cash dividend payout ratio: This is the dividend as a percentage of a company’s free cash flow. Investors can use the cash dividend payout ratio, along with the simple dividend payout ratio, to better understand a dividend’s sustainability.
- Total return: This is the increase in stock price (known as capital gains) plus dividends paid. For example, if you pay $10 for a stock that increases in value by $1 and pays a $0.30 dividend, then that $1.30 you’ve gained is equivalent to a 13% total return. This metric can be used to assess a company’s value and if it is a good buy.
Now that you know how to find a good deal, where to look to find a list of companies to choose from that have a long history of paying dividends through all kinds of financial and economic situations? We’ll cover that next.
Where To Look For Good Dividend-Paying Companies?
If you want to know where to find the best dividend stocks that provide the most consistent, reliable dividends look no further than the Dividend Aristocrats.
A company will be considered a Dividend Aristocrat if it meets the following criteria:
- Dividend raised consistently for at least 25 consecutive years
- Must be a member of the S&P 500
- Meets certain size and liquidity requirements
- Large, well-established companies that no longer enjoy supercharged growth and are recession resistant
Dividend Aristocrats can maintain their dividends since the products they sell are recession resistant and enable paying out dividends while other companies struggle.
As of 2021, there were 65 Dividend Aristocrats listed in the S&P 500. Among the companies included:
- Proctor & Gamble
- Johnson & Johnson
- 3M
- AT&T
- Walgreens
- AbbVie
As you can see, the breadth of companies included spans across literally all the major sectors of the economy.
Is this list too big for you to work with? There is an even more select list to choose from called Dividend Kings. These companies qualify by paying an increasing dividend for at least 50 consecutive years.
Some Dividend Kings are also Dividend Aristocrats but not all Dividend Aristocrats are Dividend Kings (say THAT 3 times as fast as you can! Lol 😊). For 2022, there are 44 Dividend Kings. Below are a few examples:
- Coca-Cola
- Target
- Lowe’s
- Hormel Foods
- Colgate-Palmolive
- American States Water
Whichever list you choose to use, these companies would be a good starting point for finding companies to invest in that meet your personal Investor DNA. Then you can analyze them using the metrics we talked about above to find companies that are good value based on their current stock price.
Final Word
There you have it. A complete beginner’s guide to dividend investing. We’ve talked about a lot here today. We’ve reviewed what are dividends, why important, metrics to assess a company’s financial health, and even a list of companies to start researching.
I hope today’s article pointed out the benefits of a dividend investing strategy. If setup correctly, over time, it can both increase your net worth and provide a reliable income stream to live off of for years to come.
But don’t just take my word for it, check it out yourself and leave your comments here. I’d love to hear from you.
Did you like what you read about today? Do you have ideas for future blog posts? I’d love to hear your comments.
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Until next time…….
Live The Life You Love, Want, And Deserve.