While looking at various stocks, you may have noticed something called a dividend. Perhaps you saw a percentage that denoted the “Dividend Yield,” or you saw the “Ex-Dividend Date” and the “Payment Date.” As an investor, these are important concepts to understand, especially when choosing to buy a stock. Does it offer a dividend? What does the dividend say about the company? Is there a reason a certain company is not offering a dividend? In this lesson, I will be answering all of these important questions and more.
What is a dividend?
A dividend is simply a part of a company’s earnings that is distributed to its shareholders, typically in the form of cash. The company decides how much of the dividend should be paid out, denoted by the company’s “Payout Ratio.” The ratio explains what percentage of the company’s earnings goes towards funding dividend payments.
Dividends are mostly paid out quarterly (there are four quarters in a company’s financial calendar), but can also be paid out monthly, bi-annually, or annually. You can find the payout frequency on a company’s investor relations page online.
When looking at a stock, you may see a percentage called “Dividend Yield.” This number indicates the dividend divided by the stock price, meaning the return of a stock from its dividend alone. This is the number that most investors examine; it indicates what your dividend income will be relative to your investment in the stock.
How are dividends paid out?
Typically, dividends are paid out in the form of direct transfers, which can be a direct cash payment to the investor’s account, or a check that is mailed to the investor. If you check your brokerage history, you will be able to see if a company has paid a dividend. Cash will have been added to your cash balance in your account. Another common payout method for dividends is the payment of additional shares of the company which is paying out the dividend. You can typically select this method in your brokerage account, where the option will be given to “Reinvest Dividends.”
Why are dividends important or attractive to investors?
There are many reasons why dividends are attractive to investors, but here are the main few:
1) Dividends tend to demonstrate strong company earnings and positive future outlook
No company is going to offer a dividend if it projects that it cannot afford it; after all, these are often direct cash payments to investors. Dividends come straight from a company’s earnings, so the company has to be fundamentally sound to offer these payments.
2) Dividends represent “interest” on a stock, and can be considered as direct passive income
Because of this, many investors seek dividends. They are a safe, nearly-guaranteed return each year on the stock. Not only is the investor able to buy into the stock market, but they are also getting a cash payment.
3) Dividends can often demonstrate the health of a company over a period of time
Has a company “cut” their dividend? How has the dividend yield changed throughout the history of the stock? Have investors recently voted to approve a new dividend? These are all important phenomena, and can be found through study of the dividend. They also reveal what is happening to a company, and can determine if it is a good investment or not.
Avoid dividend traps
You may have searched up “high dividend yield” stocks, and found some enticing options on sites such as dividend.com. Perhaps you saw stocks such as Dynex Capital, Inc. (DX), offering an 11.80% dividend yield. You may have seen Mesabi Trust (MSB), offering an astonishing 12.18% dividend yield. Avoid these traps. These dividends are truly too good to be true.
On closer inspection, Mesabi Trust has an average volume of 55,559, and unclear fundamentals. The payout ratio is an incredibly high 102.23%, meaning that all of the earnings are going directly to dividend payments. No money is being invested back into the company, unless the company is taking on a bunch of debt, which is another red flag.
Buy what you know
Warren Buffet always says to “invest in what you know.” The same principle applies to dividend stocks. Find good blue-chip companies, offering decent, realistic yields. Examples of this are DowDuPont Inc. (DWDP), JPMorgan Chase & Co. (JPM), and Cisco Systems, Inc. (CSCO). These are all solid blue-chip industry leaders, with dividends of at least 2%. You can be assured that you will receive your income in the form of dividends each year.
Dividends do not necessarily dictate performance
As with all things, it is important to consider all factors before making a decision. Perhaps a stock does not offer a dividend. It does not make that stock necessarily less attractive. Take Advanced Micro Devices, Inc. (AMD). AMD does not offer a dividend, but it has been one of the most lucrative technology plays in the last few years. AMD has offered solid innovation in the tech space, and has taken a strong market share in the computer parts market as a formidable competitor with both Intel and Nvidia. Just because AMD does not offer a dividend does not mean it is not a good company, with good management and strong fundamentals.
Along that same reasoning, just because a stock offers a dividend does not mean it is an attractive or safe investment. Plenty of companies offer a dividend to make themselves seem more attractive to investors, but they could be potential dividend traps, or they may have poor fundamentals.
To conclude, the dividend is just one part of stock analysis that must be undertaken. The dividend is not a make-or-break part of a stock, just one aspect to consider. Remember to be realistic when looking at the yields of companies. However, dividends are excellent sources of income from your investments, and can be potentially lucrative if used properly.