Pros and Cons of Dividends
Some people live for their dividend payout as a means to either:
- Make a regular profit
- Buy even more dividend-paying shares to increase possible future payouts
- Use the profits as part of a broader reinvestment strategy that includes buying stock as well as other securities
To this end, we will look at a trading strategy called dividend capture strategy later on, which is an aggressive way of going after dividend-paying stocks. It is also important to note though that there are some individuals, such as stock market guru Warren Buffett, who are not fans of dividends. In fact, his company Berkshire Hathaway does not pay dividends. Buffet’s reasoning is that if a company is doing well, he would rather see those funds ploughed back into the company instead of being paid out to investors.
He sees this as part of a strategy to enable further company growth long term – and paying out dividends means the company would have less internal capital growth. The company then becomes more valuable this way, as it is seen as more liquid, among other things, thus pushing the stock price up. When all things such as tax are considered, he says that ultimately investors gain more by selling off a small amount of stock – which is now valued much higher – than by having received dividends.
A Practical Example of a Stock Dividend Pay-out
Stock dividends are paid out via extra shares rather than cash, perhaps because a company’s liquid cash flow at that point in time is low due to new acquisitions, reinvestment or any number of reasons. These distributions or pay-outs are generally acknowledged as fractions paid per share. For example, a company may declare a stock dividend of 0.05 shares for each share held by existing shareholders. This may be advantageous to shareholders who do not need immediate capital as part of their trading strategy. Here is an example of how it could work.
Let’s say a company board approves a 5% stock dividend. In terms of this, existing investors are to receive an additional share of company stock for every 25 shares they own. Therefore, in this example, an investor who owns 100 shares in a company may receive four extra shares as a result of this stock dividend – but there is a caveat. This also means that the basket of available shares has increased by 5% due to the board’s decision, which dilutes the value of existing shares. Meanwhile, the total market value of those shares remains the same. A stock dividend is similar to a stock split in this instance.
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Is it a Good Indicator if a Company is Paying out High Dividends to Shareholders?
When trying to pick the best stock dividends to add to your portfolio, should you look for ones currently paying out high dividends to their shareholders? Solely looking at dividends is not reliable, as this could indicate a number of things about the company:
- The company may be undervalued.
- The company may be trying to attract investors.
If the company is paying little to no dividends, on the other hand, this is what it could indicate:
- The company is overvalued.
- The company is trying to grow its capital.
Also remember that a company may pay high dividends to its shareholders for a period and that this could later change. Companies often curtail the extent of payouts in adverse economic conditions or when they are going through tough internal periods. This is why you cannot really rely on consistent dividends on a permanent basis. Keeping this in mind also enhances your natural trading attributes. There are also instances in which a company is not undervalued despite paying great dividends. This is particularly true of corporations in certain industries, such as banks and utilities. They are often highly profitable with steady earnings and have been around for a long time, so they are not undervalued despite the fact that the high dividend yields keep on coming. Which brings us to our next section – dividend yields.
How Do You Calculate a Dividend Yield and Can You Predict Future Dividends?
A dividend yield is a financial ratio that tells you how much a company pays out in dividends relative to its share price:
- Dividend yield is shown as a percentage.
- To calculate, divide how much was paid in dividends in dollars in a given year per share of stock held by how much one share of stock costs in dollars.
- The formula is: annual dividends per share ÷ price per share.
To calculate yields for a current year:
- Take the previous year’s dividend yield, or take the last quarterly yield and multiply by four.
- For the latter, make adjustments and allowances for seasonality – it does not make sense to take a second quarter yield as an absolute when traditionally the company always closes higher in the third quarter.
- Divide by the current share price.
In picking the best stock dividends, try estimating what an upcoming dividend may be by looking at the most recent yearly dividend payment or taking the most recent quarterly payment and multiplying by four. This is called the ‘forward dividend yield.’ It’s not an absolute indication of anything, as estimates are estimates. Companies also have no compulsion to declare any dividends in the first place. You could also compare dividend payments as measured against a stock’s share price over the last year to better understand its performance retrospectively. This is referred to as the ‘trailing dividend yield.’
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How to Use Stock Dividends as Part of Your Trading Strategy
When incorporating stock dividends into a trading strategy, one of the most popular is called the dividend capture strategy. If you are a dividend capture trader, then as the name suggests, you’d try to strategically ‘capture’ a dividend. This involves buying a stock just before a dividend is declared and then selling it afterwards – the enter-and-exit strategy therefore revolves around the dividend. Dividend traders buy a stock before closing on the day prior to a company’s ex-dividend date. This ex-dividend date is the date on which you must be a shareholder on record to qualify for the next dividend payment.
As always, there is something to note: future dividends are priced into the current share price of any dividend-paying stock. Consequently, once a company has declared that it will pay a dividend, the share price will go down. This downward adjustment reflects the value that has been lost due to what is being set aside monetarily to pay out the dividend sum. The real opportunity for dividend capture traders occurs when this downward adjustment is only marginal, for whatever reason, and does not accurately reflect the future lost value.
The Potential Pitfalls of Dividend Capture
When pursuing the best stock dividends in dividend capture trade, the adage ‘buyer beware’ certainly applies. The main pitfall is that the profit margins from dividend capture are extremely thin. You may, for example, typically gain 0.29%, but this is before trading commissions and non-qualified dividend tax rates – which are usually the same as your ordinary investing income tax rate – are factored in. What does this mean? You may need to place extremely large orders if you are to gain any meaningful profit. And therein lies another caveat: having to buy large volumes come with its own set of hazardous factors, one of them being that the dividend is not the only thing affecting the lower share price after the dividend.
The share price may go even lower due to other factors that were not taken into account. So is there a way to find the best stock dividends in general? There are thousands of dividend-paying stocks, but you only want stocks that meet certain criteria, such as high-yield ones with good volume so that you are not penalised for changing a position too much. Consider consulting a best stock dividends guide, or read on for more suggestions.
How to Find Good Dividend-Paying Stocks
To help them select good dividend-paying stocks, most capture traders use a stock screener, such as Finviz, so we will use it as our example.
- Click on Screener.
◦ Input dividend yield over 5%.
◦ Average volume above 500K. Adjust as required.
◦ Price criteria above $5.
◦ The IPO must be more than 12 months prior.
- Go to the Industry drop-down menu. Select Stocks Only or Exchange Traded Funds.
- Under Fundamental, insert your personal filters.
- Click on ‘financial’ to view results in this mode.
- Click Dividend twice to ensure your list is sequenced highest to lowest in terms of dividend yield.
- Alternate the view to ‘charts’ mode.
- Leave stocks trading near the high alone. If it’s trading near the low, take a closer look.
- Manually go through the stocks on your list. As you’re doing this, open the chart platform supplied by your broker and study a chart of the stock over five years or more. Consider purchasing it if it’s trading near a major support level over that time frame and also meets the other critical relevant key filter criteria.
You can also conduct a broker comparison to find a similar service.
Dividend growth investing can cushion you with immediate and future gain streams if you’ve chosen companies that offer consistent, reliable returns. They’re not often chosen as a main strategy because the margins are so low and because the gains pale in comparison to what can happen when a share price moves up. This is why even in financial reporting, dividends are often underreported compared to up or down share price movements. It is simply not as exciting a topic. Dividend-paying companies usually declare interim or yearly dividends. They may also offer you the chance to profit through share price appreciation. As always, there are risks.
A dividend may not be declared, or it may be significantly smaller than before. If you were relying on this as your major income stream, you’d then be in trouble. The best stock dividends are probably in companies that have adopted a clearly progressive paying policy. In other words, you can see the dividend increasing every year. Again, do not take this for granted. Market conditions can change at a drop of a hat, or a company may suddenly find itself in turmoil or go in a new direction. The company’s history of dividend paying should provide you with some comfort, but never see it as a given or a certainty.