When investors are able to focus on solid and stable companies capable of making regular dividend hikes, the magic of compounding gains can turn a relatively small investment into a substantial nest egg over the long term:
Unfortunately, many beginner investors lack a basic understanding of what a dividend actually is —and what it isn’t. As it relates to a stock or mutual fund investment, a dividend is essentially a payout made to shareholders which originate as a portion of corporate profits. Dividend payments are usually made on a quarterly basis. However, there are many different types of cash distributions that are made and some of these payments are made on a monthly or even annual basis.
Basics of Dividend Stock Buying
In equities markets, shareholders must meet specific requirements in order to be eligible to receive dividend payouts. Investors must qualify as a shareholder of record on the stock’s “ex-dividend date,” which is a time period that is announced publicly by the company and is scheduled well in advance of its arrival. When market participants refer to a stock that is trading “ex-dividend,” it means the stock is currently trading without dividend eligibility. As a result, any investor that plans to buy the stock must wait until the following payout period in order to receive its dividend.
Understanding Dividend Yield
Now that we’ve covered when to buy the stock, we can now focus on the benefits (profits) that come from ownership. To understand the value of a dividend payout, we must first understand its dividend yield. The dividend yield calculation creates a ratio that compares a stock’s annual dividend in relation to share prices (represented as a percentage):
Dividend Yield = Annual Dividend / Share Price
Given the inverse relationships expressed by this equation, it should be understood that dividend yield decreases as stock prices move higher. This might seem counterintuitive at first. But it essentially means that a dividend stock is in a strong downtrend, it will become more attractive for dividend investors because its yield advantages will grow. Many beginner investors incorrectly assume rising stock prices lead to higher dividend yields. However, this is not the case. Consider the chart below, showing the daily price action in a dividend stock:
Now consider the opposing trend scenario in the exact same stock (two years later):
Dividend Yield Income Examples
Normally, dividend payments are made on a per-share basis. For example, if an investor owns 100 shares of stock, the dividend distribution will be based on 100 shares. In this example, assume the stock was bought at 10 per share (implying a total investment of 1,000) and a cash dividend payment of 1 per share (each year). As long as the investor holds a long position in the stock throughout this period, the resulting dividend yield of 10% will generate an additional income of 100 for the position.
However, if that same stock position was purchased at 20 per share, the dividend yield would be reduced by half (at 5%). As long as the same number of shares (100) were purchased, there would be no change in the total income received for the year (100). But if the higher share price forced the investor to buy half as many shares, the lower dividend yield would have a more material impact (with annual income reduced to 50).
Are Dividend Stocks Superior Investment Choices?
Now that we’ve covered the basics of how dividends are distributed, let’s move into some of the performance features that go into actual investment decisions and dividend portfolio building. In deciding whether or no dividend stocks are a good investment, beginner investors should have a sense of how these instruments tend to generate wealth over time. Consider the fact that long-term returns generated by the market’s best dividend stocks have outperformed the major stock market benchmarks by more than 200%.
However, not all dividend stocks are created equal (and some investments are certainly better than others. As noted, dividends payments derive from the profits that are generated on a company’s balance sheet. As a result, elevated dividend payments are generally indicative of strong financial health. Dividend Growers and Dividend Initiators tend to perform best over the long-term, followed by the combined average of all dividend-paying stocks, dividend-payers with no change in dividends, non-dividend payers, and company's that have reduced (or totally eliminated) their dividend payments.
For investors, building a stock portfolio full of established dividend payers can create exposure to some of the best companies in the market. Even if we don’t consider the potential returns generated by changes in the underlying share price, we can see that dividend investing outpace inflation as well as the returns of bond investments in most developed countries:
Dividend Investment Risks
In the 2008-2009 global financial crisis, most of the major banks were forced to eliminated (or at least drastically reduce) their stock dividends. Generally, these were financial companies that had a long-established reputation as being stable quarterly dividend growers (for hundreds of years, in some cases). However, macroeconomic forces were simply too intense during the collapse and dividend investors were hurt in the process.
The lesson here is that dividend payments are never fully guaranteed. Changes in the global economy or risks that are specific to individual companies will sometimes damage the outlook and limit profitability in dividend investment strategies. It’s also important to be wary of companies offering excessively high dividend yields. Remember, dividend yield rises when a stock’s share price falls. Thus, an extraordinarily high dividend payout could be a warning sign that the company is showing a weak earnings performance (and might even be in danger of cutting its dividend).
Dividend Payout Ratios
The best indicator of whether a stock’s dividend is sustainable is its dividend payout ratio, which measures dividend payments due to shareholders in relation to a company’s net earnings (expressed as a percentage):
Dividend Payout Ratio = Dividends Paid / Net Income
Companies will generally use retained earnings (which aren’t distributed to shareholders) to pay down debt, add to cash reserves, or to invest in the core operations of the business. Thus, the dividend payout ratio gives investors a sense of the amount of money a company is able to comfortably return to shareholders without inhibiting its growth. Beginner investors often buy stocks based solely on an elevated dividend payout. However, these positions could be at risk the company’s dividend payout exceeds the generally accepted safety threshold of 60%.
In most cases, intensive due diligence is required for stocks that yield above 8% (as there is a greater probability the dividend is at risk of a cut). Looking deeper into the reasons behind an elevated dividend yield can help investors decipher which companies are in a truly perilous position and which companies are simply being overlooked by the rest of the market. For stocks in the major stock benchmarks, the average dividend yield (amongst companies that actually pay dividends) tends to fluctuate between 2-5%. Of course, this is a relatively broad range and the ultimate averages seen at any given time will depend largely on macroeconomic conditions and company-specific performances.
Example Returns From Dividend Reinvestments
Last, we will take a look at some stock-specific examples in two classic dividend payers to see how a continued strategy of dividend reinvestment can enhance total returns over time. In the next chart graphic, we can see the results of a 20-year investment period:
Starting with a purchase of 243.72 shares (at 41.03 per share), the total position size grew to 485.39 shares as dividend payouts were used to buy stock throughout the holding period. This strategy raised total returns to an incredible 437.28% with almost no drawdown experienced over the 20-year period.
Even more impressive returns can be seen in the next example. In the chart below, we can see the results of a longer-term 50-year investment of 10,000 in Coca-Cola:
Without dividends reinvested, total returns on a long position would have come in at roughly 500,000 during the holding period. However, if that same investment strategy reinvested its dividend returns total returns would swell to more than four times the size (at just over 2 million over the span of the investment).