Once a company reaches its growth potential, the focus of the organization generally changes. Instead of using earnings to grow and expand the business, management may decide to start paying out dividends to shareholders. This type of activity is very common in the natural business life-cycle, as a company can no longer maintain sizable growth. By no means is this a negative indicator of the organization, but is generally viewed as a good sign the company can sustain their earnings.
Let’s take a closer look at what are dividends and how they can benefit the investor.
Investing in Dividend Stocks
What are Dividends?
A stock dividend is a distribution of a company’s earnings paid out to its shareholders. Announced by the company’s board of directors, dividends are used to distribute profits to the owners of the company – the shareholders. When a company decides to declare a dividend, it is a clear sign that management feels the company can no longer grow as fast as in the past. In order to retain shareholders as the growth of the company begins to slow, the profits are paid out in the form of dividends.
There are several advantages to investors who invest in dividend paying stocks. First, they can serve as an alternative source of income that can help supplement monies earned from a job. Secondly, a company that has a history of paying a dividend is generally viewed as a stable investment. While there are no guarantees, knowing a company has the cash to continue to increase dividends every year is a good sign.
Types of Dividend Paying Stocks
There are several different flavors of dividend paying stocks that are worth mentioning. Some companies are setup such that they pay almost all of their earnings out in dividends, while others focus on balancing dividends with the growth of the company. Each type has its advantages and disadvantages.
Here are a few types of dividend stocks that are popular amongst traders.
- REITs – A Real Estate Investment Trust or REIT is a publicly traded company that purchases real estate assets such as offices, apartments, and even mortgage loans. Based on their tax classification, a REIT is required to pass the majority of their earnings on to shareholders in the form of dividends. Based on their high yield, REITs are often a popular choice for dividend investors.
- Dividend Paying ETF – An ETF (Exchange Traded Fund) is a traded security that has the characteristics of an index mutual fund but actually trades like a stock. Many income investors seek out ETFs that specialize in dividend paying stocks. Investing in an dividend paying ETF can help diversify a portfolio while providing a source of income.
- Blue Chip Stocks – Blue chip dividend stocks are generally considered to be the most stable of income stocks. Companies that have had a tradition of raising their dividend payout annually for 25 or more years would fall into this category. While the dividend yield may not be as high for many of these companies as a REIT or Income Trust, investors typically find more stability and less risk investing in these types of securities.
Not only do dividend stocks differ in how they operate, the frequency of the dividend payments varies among companies. Here are a few of the most common dividend payout frequencies.
- Monthly Dividend Paying Stocks – Many income trusts like CanRoys (Canadian Royalty Trust) pay their dividends on a monthly basis. Investors looking for a steady monthly income stream may want to explore assets in this category. CanRoys, REITs, and other trusts usually fall into this category, as they want to quickly pass along their earnings to shareholders.
- Quarterly Dividend Paying Stocks – The most common dividend payout frequency is quarterly. Many blue chip stocks distribute their dividend payments four times each year.
- Onetime Payments – In some special circumstances, a company may announce a onetime special dividend payment. These payouts are not usually recurring and are a result of large cash balances a company is looking to distribute.
Important Dividend Investing Calculations
Those who invest in dividend paying stocks should become familiar with several financial calculations, in addition to common ones like the price to earnings ratio. Here are some of the commonly used calculations and ratios that an income investor should understand.
The current yield of a company represents the ratio of dividends paid out per year compared to the current share price. The yield of a stock fluctuates as the stock price moves up and down as well as when a company raises or lowers their dividend payout.
While an important ratio when analyzing stocks that pay dividends, the current yield can be misleading for investments that you already own. In order to calculate the true return on investment, an investor should understand the yield on cost.
Yield on Cost
Calculating the yield on cost for dividend stocks in your portfolio will help determine your return on investment. While the dividend yield is an important factor when analyzing a new income stock, it doesn’t help all that much for ones that you already own.
The dividend yield is calculated using the current share price of the stock. Instead of using the current share price, the average share price that was paid for the stock should be used to calculate the yield on cost. The results of this calculation will represent the shareholders true return on investment instead of what the stock is currently yielding.
Calculating the yield on cost is a critical step that should be performed periodically by dividend investors to evaluate the return of their portfolio.
Dividend Payout Ratio
The dividend payout ratio (DPR) is another important calculation that lets investors know if earnings can support the dividend. The DPR takes the dividends per share amount and divides it by the earnings per share. Growth companies that pay a small dividend will tend to have a lower dividend payout ratio compared to a well established blue chip company.
As a general rule of thumb, most successful dividend investors avoid companies with a dividend payout ratio above 50% or 60%. Anything above that mark means the company may not be investing enough capital back into the organization. Even though a company’s growth has slowed, it is still critical to reinvest a portion of earnings back into the organization.
Investing in dividend paying stocks can be a great opportunity to create a new source of income. There are plenty of income producing stocks ranging from monthly paying REITs to traditionally stable blue chip stocks. Once an investor decides to begin investing in income stocks, it is important that they understand several ratios such as dividend yield and yield on cost. These ratios can help investors analyze stocks that they are considering buying or selling.
Do you invest in dividend paying stocks? What experiences can you share – good or bad?