What are dividends? Why should you care?
December 20, 2011
Dividends aren’t just something rich people talk about, or a Community Chest card in Monopoly. They are the most consistent and easiest way to gain passive income as an investor. When most people think about investing in the stock market they think about movies where young men with slick hair invest in little-known companies and then profit hugely when these companies suddenly explode. The phrase, “Buy low, sell high,” rolls off of most peoples’ tongues. The fact is that this not how most people get rich, and it doesn’t really do the stock market justice. Over the past 40 years almost 60% of the overall yield of the entire stock market was produced by dividends as opposed to capital gains (capital gains refer to the money you make as a difference between what you bought your stock at, and what you sold it for). That’s an amazing statistic when think about it. Investing with a focus on companies that have a strong record of producing consistent dividends has many advantages over other, more risky styles of investing.
The actual definition of a dividend is cash that is distributed to shareholders from a company’s earnings. The amount of your dividend is determined by the number of shares you own, and the dividend that the company is paying out. The dividend is usually listed as the amount per share (so you simply multiple this number by the number of shares you own in order to get your overall payout). The dividend is paid for with after-tax money from the company. Some companies pay their dividends quarterly (the most common), while others payout bi-annually, monthly, or annually. Regardless, the number you are most likely to read is the dividend prorated over a year. In order to determine a company’s dividend ratio, you divide its annual dividend, by the current cost per share. These two metrics are the most important ones to look at when doing dividend investing. The higher the dividend ratio, the more money you will receive back as a percentage of your principle investment.
I think all investors should look very hard at dividend investing, especially in today’s income-starved investing climate. There are several very strong dividend payers like AT&T for example, that are offering yields that are double, or even triple what the 10-year bond rates are on American Federal debt. By investing in these companies you are getting paid every year, and any value the company gains while you hold the stock is the “cherry on top” of your investing sundae. To stay consistent, if we keep AT&T as our example, their current dividend ratio is 6%. If you were to spend your dividends every year, you would have gained your principle back again in under 20 years (plus you would still own the shares you bought)! The real power of dividend investing occurs when you keep reinvesting them however. This allows compound growth to truly work wonders. If we think that AT&T might grow at an ultra-conservative rate of 3%, and keep their 6% dividend ratio, then we assume that all our dividends will be reinvested, your original principle will have doubled in only 8 years! In the long term, you could easily see your money double 4 or 5 times. Also keep in mind that great dividend paying companies typically increase their dividends over time. For example Coca-Cola has had 48 years of consecutive dividend increases. Procter & Gamble – 55 years of consecutive dividend increases.
Another reason why dividend investing is so attractive to many investors is because of the simple fact that if a company is paying a dividend, and has a strong history of paying/raising a dividend, these are two of the best indicators of the overall growth and maturity of a company. Think about the basic logic, if a company can afford to consistently pay shareholders, they have proven that they have sound management, and a pretty good business model. It is extremely rare that a company that has a good history of paying out dividends suddenly goes into bankruptcy. Instead, these are the companies that generally have the economic stability to withstand challenging conditions, and emerge with a stronger market position in spite of them. For example the Coca-Cola company has been paying dividends since 1893.
Dividend investing is a great way to give yourself a consistent stream of positive cash flow as an investor, and is a very useful way to screen out stocks that are too risky. They hold up very well during recessionary periods (like the present one) because their dividend payouts are so attractive to investors that need immediate money from their investments, and the capital gains they experience during a bull market provide a nice overall return for patient investors as well. These are some of the main reasons that dividend investing has always been, and assuredly will continue to be, one of the most solid long-term and short-term investing strategies in the marketplace.
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Reader Comments (4)
Nice post. In additon to the points you make, dividends impose a discipline on management since they are reluctant to reduce them and they can't be clawed back should management make bad investments with company funds.
Teacher Man!!
You are everywhere lol!
Great post :)
I wasn't into dividends until recently when I became enlightened. I'm glad I found them because now I'm addicted.
@miltonf thanks for dropping by. You make a good point, dividends can not be taken back once they are issued....I consider this my margin safety against poor management.
@youngandthrifty I'm glad you've become enlightened. My goal is to enlighten as many people as I can about dividends! :)
I'm honored to have Teacher Man post on my blog!