Would you rather someone gave you a small amount of money now or a larger sum in the future? That's a question to ponder when deciding whether to invest in a company. But what if there was a middle ground — a way to enjoy some money now, or in the near future, and get your big payout later? There is, and below, we'll look at how you can cash in on it.
What do companies do with their excess earnings?
Sometimes, companies make too much money — yes, really. There's only so much they can put back into their business, and sometimes, they end up with money left over. When this happens, some businesses choose to give the extra cash to their shareholders in the form of a dividend. This also helps make the company more attractive to investors.
These dividends are a small portion of the company's extra cash, and they're usually paid to shareholders quarterly. How much you'll get depends on how much of the company's stock you own and how it's been doing recently.
Dividend stocks appeal to a lot of investors because they can provide a steady source of income without forcing you to sell any of the stock you already own. Many brokers even allow you to reinvest your dividends automatically to buy more shares of the stock. This is called a dividend reinvestment plan, or DRIP. It can help you grow your nest egg more quickly (and earn even more dividends) than you could if you were just working with your own personal contributions.
But before you get any wild ideas about getting thousands of dollars in dividend payments every quarter, you should know that dividends are usually only a few cents to a few dollars per share. If you own 100 shares of a dividend stock that pays you $1.50 per share quarterly, you'll get $150 in dividends every three months.
Dividend stocks also typically don't see their share prices appreciate as quickly as growth stocks do, but they're also usually less volatile than growth stocks. That means they're less prone to the sudden swings in share price that could lose money for you.
A falling share price isn't the only risk with dividend stocks. Companies aren't required to keep paying dividends in the same way they're required to make interest payments on bonds. Dividends can stop or decrease without warning, so it's important to choose your dividend payers carefully.
Where should I look for good dividend stocks?
A great place for beginners to start looking for dividend stocks is the list of S&P 500 Dividend Aristocrats. These are the companies in the index that have paid and consistently increased their dividends every year for at least 25 consecutive years. There's also a more elite list, known as the Dividend Kings, with publicly traded companies that have consistently increased their dividends annually for at least 50 consecutive years.
These companies are pretty safe bets if you're looking for a steady source of dividends, though even they aren't immune to problems. During the Great Recession, many banks fell off the Dividend Aristocrats list as they became unable to pay or increase their dividends due to financial strain on the companies.
Some common metrics used when comparing dividend stocks are dividend yield and payout ratio. The dividend yield is the annualized dividend, represented as a percentage of the stock price. For example, if a company pays $1 in annualized dividends and its share price is $25, its dividend yield would be 4%. Currently, the dividend yield of the average stock in the S&P 500 is 1.35%, but ideally you'd like to see a dividend yield between 2% and 6%.
Dividend yield moves in the opposite direction to share price, so when shares rise, yields tend to fall and vice versa. When you buy a good dividend payer on a dip, you're essentially locking in your yield for those shares. Even if the current dividend yield drops after you make your purchase, you still get the yield based on your initial purchase price, assuming, of course, that the company can continue paying dividends to shareholders.
For example, say you bought a stock for $20 and it pays you $1 per year. That's a 5% dividend yield. If the stock's share price later climbs to $30 and it still pays shareholders $1 per share per year, the dividend yield for people buying the stock for the first time is only 3.3%. But you're still earning a 5% yield because you bought the stock when its share price was only $20.
It's tempting to focus solely on dividend yield when comparing dividend stocks, but that's a classic beginner's mistake. You also want to consider how sustainable the dividend is — that is, how likely it is that the company will be able to continue paying dividends to its shareholders over the long haul.
That's where the payout ratio comes in. This is a measure of the dividend as a percentage of the company's earnings. So if it earns $1 per share in net income and pays shareholders a $0.25 dividend per share, its payout ratio is 25%. A low payout ratio is a good sign that a dividend is sustainable, while a higher payout ratio suggests that the company's current dividend yield may not last for long.
The definition of a low payout ratio varies by industry. In slower-growing industries, anything under 75% is considered good, while in fast-growing sectors, the ideal ratio is under 50%. Anything over this is considered high.
It's also a good idea to look at the company's business model and its industry to determine if it's a smart investment for you right now, apart from the dividend. Remember, dividends are only part of the equation. When you sell your stock someday, you'll also turn a profit if the share price has gone up since you first purchased the stock.
As with any type of investing, the keys to success in dividend stocks are patience and careful planning. Dividend stocks aren't going to make you rich overnight, but they can make a great addition to your portfolio, either as an additional source of income now or a way to grow your nest egg even faster.
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