Often, dividends are after overlooked as an investment strategy. Some stocks pay regular dividends to investors, and this income can prove a nice boost to your investment income. Historically, dividend stocks have outperformed the S&P 500 and experienced less volatility due to the dual income they provide.
Aside from the regular income from dividend payments, the stocks have the potential for capital appreciation as with equities. Since dividend stocks tend to be less volatile than other options, they often appeal to people who want lower-risk investments. At the same time, investing in dividend stocks can be confusing for first timers.
A Breakdown of How Dividend Stocks Work
Dividends are regular payments made to investors by companies. Imagine a company with a dividend of 30 cents per share. While this does not sound like much, it can really add up. If you purchased 100 shares of the company for $10 each, you would get $30 in dividends for an investment of $1,000, which is a 3 percent yield. This is not bad considering you will also likely experience capital appreciation over the same period.
Importantly, dividends are paid out whether the price of the stock increases or decreases, so it is a somewhat guaranteed income. If the company does not have the money to pay dividends, you may not receive the income, an issue that has become more common during the COVID-19 pandemic.
The dividends that you receive from these stocks can be used any way you see fit. Many people choose to reinvest the money and purchase either more shares of the company or a different stock entirely. However, you may also simply save the cash or funnel it into other investments. Alternately, you can cash out and choose to spend the money in your everyday life. While not all companies have been able to pay dividends during the pandemic, a number have maintained these payments. Creating a diversified portfolio of dividend stocks makes it more likely that you receive at least part of these payments.
The Terms to Know When Investing in Dividend Stocks
Stocks that pay dividends have their own vocabulary you should be familiar with. These terms and calculations will help you evaluate stocks to choose the best ones for you. The first term to know is dividend yield, which is the dividend over a year represented as a percentage of the stock’s current price. If a company pays $1 per share annually and has a stock that costs $10, then the dividend yield would be 10 percent. This number helps you compare different companies easily. Another term to know is dividend payout ratio, which is the dividend as a percentage of a company’s net earnings per share. A lower payout ratio is more sustainable for a company.
You may also encounter the cash dividend payout ratio, which is the dividend as a percentage of the company’s operating cash flows without capital expenditures included. This number is a surrogate for dividend payout ratio, as net income is not a cash measure and non-cash expenses can cause earnings and thus the ratio to fluctuate a great deal. If you see a lot of fluctuation in the dividend payout ratio, look for the cash dividend payout ratio. Also, pay attention to earnings per share, which is the per-share value of profits. Ideally, companies can increase this number over time and thus pay out larger dividends. Dividend stocks also report total return, which is the capital gains plus dividends paid to account for the entire return on investment.
Points to Keep in Mind About Dividend Stock Investing
Many people often make the same mistake when first investing in dividend stocks. A stock with the highest dividend yields is not necessarily the best option. Remember that high yields can be the result of a falling stock price, and the dividend could be at risk of being cut. This is known as the dividend yield trap.
Companies that have significantly higher dividends than their yields are often in danger of collapse. Always use payout ratios to gauge the sustainability of a dividend before you invest. You can also look at the history of a company’s dividend in terms of both payout growth and yield. A strong history does not guarantee that the company will continue paying dividends, but it is much more likely.
Another thing to think about before you invest in dividend bonds is what you will do with the payment. If you choose to reinvest it, you can do so manually or opt for a dividend reinvestment plan, which is known as a DRIP. This plan will reinvest dividends without any fees or commission back into shares of that company. Using this plan is a simple way to capitalize on the power of compounding without having to take any action on your own.