Collecting Rich Dividends

 

Dividends can help build wealth.

 

What’s In A Dividend?

 

If you own no stocks at all, the idea of owning a particular type of stock may seem rather silly.  However, if you have some savings or retirement money set aside, and are discouraged by the low interest rates banks have been offering, then it may be worth considering the alternatives.  One alternative to a savings account that can work to generate regular income is to buy dividend paying stocks.

 

The Basics

 

Profit can be paid in dividends or reinvested.

Management decides how or whether to reinvest profit.

What’s a dividend?  A dividend is a special type of income that represents a per share portion of a corporation’s profit.  This is the portion of profit that management decides to return to the shareholders of the company (i.e. its investors).  This means you need to own stock to collect dividends and the number of shares you own will determine your overall dividend income.  For example, say the company’s management declares an annual dividend of 50 cents per share and you own 100 shares.  Your dividend will end up being $50 (that’s $.50 x 100).  Now, if each share is worth $10 on today’s market, that means you hold a $1000 stake in the company (i.e. $10 x 100).  Thus, the dividend above represents a 5% yield.  For purposes of comparison, yield is a rate of return given as a percentage and is therefore similar to the interest on a savings account.

 

Yield is calculated by dividing overall dividend income by the market price of the stock shares—that’s the price you can sell your shares if you sold them today.  Note we converted the decimal in our calculation to percent by multiplying by 100 (in this case $50 divided by $1000 = .05 x 100 = 5%).  Since passbook savings accounts are currently paying anything from ½% to 2% interest, a 3% to 5% dividend yield (which is not uncommon) could represent a significant boost to an investor’s income.  Thus, it may be worth consideration as a wealth building strategy.

 

A Word On Risk

 

A tree cutter risks constant injury.

Just as some jobs carry more risk, some stocks do, too.

There is risk in owning stocks—and sometimes we need to look deeper to understand just exactly what that means. Investors should understand they can lose some or all of their investment capital when they buy a stock.  However, risk is a two-edged sword—it cuts both ways.  Investors can also make money on a stock’s appreciation, sometimes doubling or even tripling their investment.  Stocks are traded every day on the market.  There are a number of reasons a stock’s share price may go up or down each and every day.  I’m going to discuss five of the most important reasons here:

 

1) Fundamentals

 

At any time, a company’s stock shares can go up or down due to a change in the company’s “fundamentals”.  Fundamentals refer to the financial aspects of running a business.  For example, if the companies sales go up and management keep costs under control it will have more cash to pay down debt.  For investors, when a company reports growth in sales, cost control measures, increased earnings, higher productivity, the opening of new markets, reduction in debt, and so on, it may make the company shares more attractive to own.  However, should costs go up or debt get out of hand share prices may plummet.  Many investors and stock analysts consider fundamentals like these as they determine the value of a stock.  The decisions or recommendations they make regarding a stock may change as a result—for example from buying to holding or selling.

 

2) Technicals:

 

Technical Analysis is a tool many investors rely on to try and predict either a single stock or security’s direction in the market, the direction of a market segment, or even the direction of the market as a whole.  Technical analysts believe past history of a stock’s price (rather than or in addition to a stock’s fundamentals) is often the main driving force that pushes it up or down.  Technical analysts therefore create charts that track a stock’s performance, believing patterns in the charts can often signal a psychologically valid buy or sell point for a stock.  The charts may include the price of a stock, changes in volume (or supply and demand), moving averages, advance/decline lines, changes in options,  put/call ratios, etc.

 

Here's the stock price chart for Company B.

Technical analysts look at charts to find patterns.

Technical analysts rely heavily on human psychology to predict patterns or directions stocks are likely to take.  Their recommendations can and do influence a stock’s price and the market as a whole.  How?  A buy recommendation might result in investors purchasing a stock and a sell recommendation might do the opposite, or it might allow those using hedge tools like options, puts/calls and deriviatives to take steps that could help push stocks up or down.  Though some investors are convinced technical analysis is unscientific and therefore of little value, others swear by it and make some or all of their investment decisions based on “technical” indicators.  Bottom line: When enough people believe in and use any system, it can and does affect prices.

 

3) Speculation:

 

Speculation about a company can also affect a company’s stock price.  Example: If a company manufactures medical equipment and files several new patents on its inventions, investors may buy additional shares as they “speculate” that new products will substantially boost income. The extra demand for the shares will raise its price.  Here’s another example: If a major resource like copper takes a huge price hike, investors might sell shares of a certain company because they may know it uses a lot of copper in its products and that will make those products cost prohibitive.  Or consider this situation: Say a company’s share price has been falling for some time, but the company is still a fundamentally sound operation.  If the stock price falls far enough, a second company may think to buy the company and absorb it into their own operation.  If there’s a general perception a buyout makes sense, then speculators might buy the stock in anticipation of a deal.  They’ll do that believing that as soon as any buyout is announced, the company’s stock shares will jump in price. There are also other forms of speculation involving options or derivatives, but these are more complicated and beyond the scope of today’s topic.

 

4) The Economy

 

Share prices can also be affected by the economy: If all the companies in a region or throughout the entire economy are suffering because of a recession, then more people are out of work and fewer people may be able to afford the company’s products.  With sales going down, investors may value the company’s shares at a lower price.   Inflation is another economic force than can wreck havoc on a company. If the company’s products become too expensive to manufacture because costs go up, then the company will have to raise prices.  Depending on their ability to do that, it could significantly cut into sales.  Economic forces can also be international in scope.  Emerging Market conditions may impact where products are manufactured, who buys critical scarce world resources, the shipping costs to deliver a product to its market and much more.  The bottom line is that economic matters influence stocks on a worldwide scale.

 

5) Unforeseen Events

 

There's no way to predict what happens next.

Unforseen events add fear and that upsets the markets.

Sometimes, a company’s stock will go up or down for reasons that have nothing to do with it.  For example, if Competitor B suddenly offers a new “breakthrough” product, Company A may suffer because investors anticipate a rapid decline in its sales—as more people start buying B’s product, there will be fewer buying A’s.  Or say the threat of war breaks out in a far off land.  This may affect the whole market.  People tend to panic in certain situations and when fear goes up, the markets often take a tumble.  The opposite can also be true: If a world threat fades away, the markets will generally go up.  There are endless unforeseeable events that may trigger a sudden spike or drop in either a particular stock or the market as a whole.

 

Risk Determines Reward

 

The point in discussing how the stock market goes up and down is to make certain that potential investors understand the risks in investing in a particular stock aren’t limited to the company itself.  This is different than banking—Investors putting their money in a savings account at their bank have almost zero risk because the government guarantees the bank’s deposits through the FDIC.  No such guarantee exists when owning a stock.  That means investors should exercise great care when considering whether the investment is one they’ll be comfortable with.

 

To get a better understanding on risk and determine what kind of investor you may be, see our post (What Kind Of Investing Is Best).  Or many websites like this one at Vanguard.com offer quizzes that can help determine your willingness to tolerate risk.  This can be helpful in determining the types or mix of investments that will cause the least amount of anxiety as you invest funds in the market, though there are no guarantees.  We should also note that sites like this who sell investments may have an agenda to steer you toward the products they offer—that’s not bad in itself, just something to consider.

 

Which companies pay dividends?

Not all companies pay dividends, but many do.

Back To Dividends

 

Not all stocks pay dividends.  The management at those companies that are still in a major growth phase (i.e. usually those companies in their early years), will typically choose to reinvest all profit back into the company, rather than pay a portion of it out as dividends.  In recent years, even large companies whose growth rate has peaked sometimes prefer to reinvest profit rather than distribute it through dividends.  This means that investors seeking to increase income by buying dividend paying stocks will most likely be seeking out certain well-established firms that have a long record for paying consistent dividends over time.  It’s also important to understand that since stocks appreciate or depreciate in price, an investor’s total return on any particular stock purchase is going to be determined by both its share price fluctuation and the accumulation of any dividends.  Let’s look at an example to see how this works.

 

How Dividends Add To Return

 

For our purposes we will not include the cost of either commissions or taxes, but in the real world both will impact your actual return.  Now, suppose you buy 100 shares of Company A at $10 and hold those shares for two years before selling them for $15 per share.  Also assume you received eight quarterly dividend payments from the company during the period your own the stock at the rate of 15¢ per share.  What’s your total return?

 

Step 1: First calculate how much money was originally invested:

 

$10 x 100 shares  = $1000

 

Step 2: Now calculate how much money was collected when you sold the shares:

 

$15 x 1000 shares = $1500.

 

Step 3: Subtract your original investment from the price you sold at:

 

$1500 – $1000 = $500.

 

Congratulations, you picked a winner.  Your stock appreciated $500.

 

Step 4: Now calculate your dividend income:

 

100 shares x 8 payments x $.15 per share = $120.

 

Congratulations, again!  You made an extra $120 off your stock because it paid dividends. (This is a simple example and assumes all quarterly dividend payments are the same.  There is nothing that says a company has to pay out the same dividend each time.)

 

Step 5: Calculate your total return:
 

$500 of appreciation + $120 in dividends =

$620 total return.

 

Step 6: Now, calculate the total return on your investment:

 

Divide your total return of $620 by

your $1000 investment.

 

The answer is $620 / $1000 = .62 or to convert to percent: .62 x 100 = 62%.  Note: This is not an annual return.  To get the annual return divide 62% by 2 (remember we held this stock for 2 years) and you get 31%.

 

 

The Power of Dividends

 

Pennies turn into dimes and dollars over time.

A 15 cent dividend may not sound like much, unless you consider it applies to every share, every time a new dividend is declared.

Do you see how dividends added to our overall return in the example above?  Without dividends, the return would have been $500 / $1000 = .5 or 50% for 2 years.  That would be 25% annually.  Though a 25% annual return is a very nice return, the dividends received in this example added 6% to the annual total and made it even better (25% + 6% = 31%).

 

Perhaps you are now thinking about the potential here and have realized that a drop in stock prices would also be offset by any dividend income a stock generates.  In this case, if stock prices had declined by 2% overall, investors would have still received a 10% return on their money (12% – 2% = 10%).  To make sure of our math here, $120 / $1000 = .12 x 100 = 12%.  Thus, 12% represents our total return from dividends alone.  Now, subtract the 2% market drop and you end up with a total return of 10%.  Perhaps it should go without saying, but if the stock price fell by more than 12% the overall return would be negative.  However, no matter whether the stock price goes up or down, the dividends are still paid.

 

→ This means dividends pad a gain or soften the blow from a loss.

 

All Dividends Are Not The Same

 

To complicate matters, companies can choose to pay dividends or not.  They can also choose to:

 

(1)   Pay a dividend just once, or on a more regular basis.

(2)   Pay dividends quarterly, semi-annually or annually.

(3)   Pay special dividends above and beyond the usual dividend.

(4)   Pay varying dividend amounts each time around or,

(5)   Pay an amount different than any other company.  For example, one company’s dividend yield may be 2% and another company’s yield may be 10%.

 
Why would companies pay different dividends? The amount of the dividend may depend on the company’s profitability, on the cash on hand to pay a dividend, or on management preference to set or maintain a particular dividend yield. In addition, more often than not, investors can expect that the higher the yield rate, the greater the risk in owning the shares. This means that the stock share price of those companies paying a 10% yield will tend to fluctuate more than the share price of a company paying 2%. However, there are no set rules, and ultimately it comes down to a decision by management to decide what makes their stock most attractive to investors.

 

Finding A Good Dividend Stock Goes Beyond The Numbers Alone

 

When trying to decide which stocks might be the safest bet to add to your portfolio you want to look beyond the numbers to get the real story.  Sometimes, companies in trouble offer the highest dividend yields—you may want to avoid these firms if you’re more risk averse.  As you’re looking at potential dividend paying investments, it’s best to look at a company’s valuation, what’s happening in the industry as a whole, whether sales and growth are trending up or down, if the company is in the news for some reason, and so on.  Fortunately, with the power of the internet at your disposal that are hundreds of options for investigating a potential stock investment.  Some sites like MotleyFool.com, MarketWatch.com, YahooFinance.com, GoogleFinance.com, WallStreetJournal.com, CNNMoney.com and CNBC.com are jam packed with information, tools and user forums.  Much of it is free.  If you’ve never checked them out before, it’s worth spending some time to find a favorite.

 

Professional advisors are available to help with investing choices.

Investing information is available in a variety of formats.

Many stock trading professionals also offer daily, weekly or monthly investment advisory newsletters for a fee with the intent of steering you toward the best investments.  This isn’t limited to stocks as these services also recommend bonds, commodities, funds, options, etc.  Before paying for a service, do a bit of sleuthing to check its record first.  There is even a service that ranks all the various advisory services.  Mark Hulbert is the editor of the Hulbert Financial Digest, which has been tracking the performance of the various investment newsletters since 1980. Though he offers a 30 day free trial, his one year service goes for $99.  As a rule, investment newsletters go anywhere from tens to hundreds, or even to thousands of dollars every year, though it turns out their price isn’t a very good predictor of their overall record of success.

 

There is actually so much information out there regarding stocks and investing it is easy to get overwhelmed pretty quick.  We recommend you start with two or three sources of news or information you trust and stick with them until you get more comfortable with stock and investment terminology.

 

How Do I Pick A Good Dividend Paying Company?

 

With the understanding that there are no guarantees when it comes to stock investing, start your search looking for:

 

1) Solid companies, that are well-established in an industry.

2) Companies who have a consistent track record of paying dividends.

3) Companies whose dividends have increased over time.

4) Companies whose stock prices tend to fluctuate less in a downturn.

5) Companies who have a good balance sheet (meaning have little debt and lots of cash).

6) Companies who are growing and have a consistent pattern of growth throughout the years.

7) Companies whose market valuation puts them in the big leagues (i.e. mid or large cap firms).

 

One Method That Bypasses Doing It On Your Own

 

Rather than seek out individual companies that pay dividends, you can also buy a “collection” of dividend paying companies in the form of a Mutual Fund or Exchange Traded Fund.  These funds are often either actively managed (more common with a mutual fund) or they are based on a model which tries to replicate an index for a specific industry or the market as a whole (more common with an exchange traded fund).  Vanguard is just one of dozens or even hundreds of such companies that offer Mutual and Exchange Traded funds (ETFs).

 

Mutual Funds and ETF's are traded by many companies.

Find a company you trust and check out their mutual or exchange traded funds.

We are not licensed investment advisers or affiliated with anyone who is and therefore cannot recommend specific stocks or funds as a part of this post—every investor must make those choices themselves.  However, we can provide a few examples of “dividend-paying” funds to let you know they exist and are probably worth further investigation.  Vanguard offers the mutual fund Vanguard Dividend Growth (VDIGX) and the exchange traded fund Vanguard Dividend Appreciation ETF (VIG). I-shares offers the I-shares Dow Jones Select ETF (DVY).  State Street offers the SPDR Dividend Fund (SDY).  There are many other “Dividend” oriented funds as well as funds for any other segment of the market you can think of.  Though all funds carry certain fees, the people running them do their best to come up with a selection of stocks that they feel should provide a decent return over time.  Again, we should point out any fund carries certain risks of loss along with the potential for gains.

 

What goes unsaid when you buy any fund is that it will contain some stocks that perform well and some that don’t.  There’s no way to guarantee it, but by owning a collection or mix of companies within the fund you come out with an average that is hopefully good enough to meet your objectives.  In a sense, this is one way you can diversify your portfolio.  Diversification is a concept that allows you to spread the risk around.  If you owned just one or two stocks and either one took a significant dive in price, it might wipe you out.  On the other hand, owning dozens or even hundreds of companies through a fund significantly reduces the risk that a loss in any one stock will have the same impact.  For some additional thoughts on diversification, see our post: Diversification: A Safe Money Machine.

 

One Method for Coming Up With Your Own List

 

If you’ve decided you prefer to try finding stocks on your own, begin by searching for the “best dividend paying stocks” on your favorite search engine.  Most likely you will be directed to hundreds of articles or posts that describe some expert’s opinion on companies they believe are the best bets.  Don’t jump at the first thing you see and pay attention to the date of the post (some articles will be several months or years old).  There will be many choices to consider as you widen your investigation, so start making a list that includes the name of the company, where you heard about it, it’s stock ticker symbol, last dividend, yield rate, etc.  Once you have a number of stocks on your list you can narrow it down and dig a little deeper into your top candidates.  You can also check the news for any important information that may not be included in the financial reports you find.

 

Instead of using a search engine to hunt and peck for specific stocks, you can also look for a mutual fund or exchange traded fund that is known as a “dividend” fund (like those listed above).  If you look at the portfolio of the fund at most financial sites or brokerages, it should list at least 10 or so of the funds top holdings.  If you look at the fund’s prospectus (which is often available directly on the fund’s website) you should get a list of some or all of the funds holdings.  In either case, you can use this list to start comparing various dividend paying companies.  If you find several funds, you can also cross compare and see what companies are the same in each fund and which ones are different.  If you come up with a list of potential candidates this way, go to a sit like YahooFinance, find their investing page and see how the company is doing to narrow your choices.

 

Math Making You Cross-Eyed?

 

The math for investing if fairly straightforward.

Your online brokerage account can give you up to the minute details on your gains and losses.

If all the math in today’s post is making you cross-eyed, you may be happy to discover that most stock brokerage firms (i.e. the companies that help you buy and sell shares of stock) offer you a daily view of your investment gains and losses so you won’t have to do all these calculations by hand.  They also, typically offer great resources for evaluating different companies online, or they may offer more personalized stock recommendation services for a fee.  We’ll take up the issue of stock brokerages on another day, but either way, rest assured brokerages want you to have a pleasant experience with them as they make money by buying and selling you shares of stock.  That means, you need not be afraid to ask lots of questions any time you require more information.

 

The Nitty Gritty On Dividends: Dates Matter

 

There is one final note on dividends that potential investors should be aware of.  This relates to the manner in which dividends are paid.  There are a number of dates that become important.  These are listed below:

 

1) Declaration date: On this date a company’s board of directors announces that the company will pay a dividend.

2) Ex-date or Ex-dividend Date: This is an important date if you’re planning to buy or sell a stock.  If you buy your stock on or after this day, you won’t receive the most recently declared dividend. If you buy before this date you do get the dividend.  If you plan to sell your shares and want to receive the dividend, you’ll need to sell them on or after this date.  If you need your investment money quickly and don’t care about the dividend, you can sell anytime.  Finally, this date usually falls on the second “business” day before the date of record.

3) Date of record: This is the day the company looks at its records to determine who owns shares in the company.  In order to receive their dividend, an investor must be listed as an official stockholder of record the day before the ex-date.

4) Date of payment: This is the day the company actually mails out its dividend checks.  This date typically follows the date of record by a week or more, giving the company ample time to verify that those receiving dividends have qualified to do so.

 

When do you get your dividend?

Ex-date? Date of Record? Dates are important in investing.

These dates are critically important if you are relying on the income from dividends, or if you choose to buy or sell your shares of stock and still want to receive the dividend.  It’s also important to understand that experienced investors know what these dividend dates imply—they expect a stock’s value to drop by the approximate value of the dividend on the ex-date.  It won’t be exact because of market conditions or tax consequences, but since investors understand the company is reducing its cash by paying a dividend they will offer less for the shares.  As far as an individual investor is concerned, you either receive dividends in the form of cash directly or through your broker or will have instructed your broker to reinvest your dividends in additional stock shares (or fractional shares).  This means a “drop” in the stock price that is due to a dividend payout isn’t the same as a loss on your investment.

 

Good Investing

 

We hope that today’s post has given you enough information to start considering whether adding dividend paying stocks to your portfolio should be a part of your overall investment strategy.  If you’re looking for a good source of additional information on investing, start with Investor.gov, a site maintained by the U.S. Securities and Exchange Commission. It contains many useful links, questions to ask as you get started investing, information on brokerage firms, scams to watch out for and more.

 
We encourage you to thoroughly investigate all potential investments and/or seek professional guidance before risking any of your funds.
 

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