Published on September 6th, 2017
This is a guest contribution by Freedom Financial Network.
If you’ve considered investing in stocks, you’ve probably come across the concept of dividend investing.
The terminology can make it a bit confusing, but once you get past a little bit of jargon, it will quickly become clear that dividends are powerful investment tools. Freedom Financial Network isn’t in the business of picking the hottest stocks, and you shouldn’t be either, but knowing how dividend investing fits into your portfolio can be very valuable.
What are Dividends?
Dividends are paid out in cash to stock investors. When a company has earnings left over after paying its expenses, it has two choices—reinvest the earnings or pay the earnings out to investors. Since companies must balance pleasing investors in the short and long term, this choice is not always simple. Investors are always happy to get extra money in dividends, but if that money is going to go into profitable business activities like research and development it may be worth it to make investors wait.
Knowing that, it becomes clear why high-growth, young companies generally pay low or no dividends while low-growth, mature companies have the highest dividends.
A company like a tech start-up—take Snapchat, for example—can make a much larger return on its money if it invests all of its earnings on its business as opposed to paying those earnings out. Conversely, a mature tech company—think Apple or Microsoft—gets to a point in the business cycle when the potential returns on their money no longer outweigh the benefits of paying earnings out to stockholders.
How do Dividends Fit Into my Portfolio?
Freedom Financial Network, along with most financial professionals, knows that investment choices boil down to two main factors—risk and return. If you imagine every stock existing on a spectrum of least risky to most risky, stocks that pay out high dividends are generally on the less risky side of the spectrum.
Of course, if an investment (in this case, a stock) is perceived as relatively low-risk, the return it generates in price growth will generally be lower. That’s why dividend stocks would be considered a low-growth, low-risk, income-generating stock investment.
Dividend Stocks Still Have Risk
Despite regulators’ best efforts, earnings are often murky and hard to pin down for investors in public companies. Sophisticated analysts spend their careers trying to estimate a company’s earnings, and even they can only make a best guess. But even though dividends give you the peace of mind that a company does indeed have solid earnings, Freedom Financial Network wants everyone to know that dividend stocks are still common stock.
And when a company goes bankrupt, common stockholders get nothing.
When Should You Invest in Dividend Stocks?
Investing in dividends could be appropriate for a wide range of investors at almost any time in their life, the Freedom Financial Network has found.
Young investors will benefit from the regular cash flow of dividends, especially if they reinvest those payments. By setting up a system where your dividends get automatically reinvested, you’ll take advantage of your long investment timeline by leveraging the power of compounding returns.
As you age, you’ll want to slowly pull back on the amount of risk you take in your investments. The closer you get to retirement, or the sooner you need to take money out of an investment, the less time you have to weather volatility. Because of this, many older investors choose to allocate their resources towards bonds. Bonds are generally considered much more secure than stocks, but they don’t give you much of an opportunity for growth.
While bonds might work well for many older investors, some investors who can tolerate more risk could benefit from investing in dividend stocks. A dividend stock gives the older investor the steady income stream they need when they are retired while also providing the promise of potential price appreciation.
Again, this all depends on your appetite for risk as well as your personal financial circumstances. There isn’t a one-size-fits-all approach to investing in the stock market.
How to Tell if A Dividend Stock is “Good” or Not
You’ll hear many different arguments about what constitutes a good dividend stock and a bad one. Freedom Financial Network won’t wade into the debate because it truly depends on your risk appetite and your financial goals. That said, there are several measures that are helpful to familiarize yourself with to better understand the factors surrounding a dividend stock.
The first, most basic measure of a dividend stock is the dividend yield, which is the percentage of a stock’s current price that the company pays you in dividends. For example, if a company you’re investing in says it pays $1 per share and its price per share is $40, then your yield is 1 divided by 40, or 2.5%.
There are many more measurements you can look at, but some of the most important are as follows:
- Dividend Coverage Ratio—essentially the amount of money (net income) that a company has compared to the amount of dividends that it pays out. Generally, a higher dividend coverage ratio means the company has plenty of money to cover its dividend payments, so your dividend is safe (in theory).
- Free Cash Flow to Equity—money coming into a company is accounted for in a wide variety of ways, making it confusing to understand how much money a company actually has available. Free cash flow is the amount of money a company has after paying all its expenses. Here again, a higher ratio indicates more safety in your investment.
- Dividend Payout Ratio—this ratio compares the earning per share against the dividends per share. It shows you how much of net income is paid out in dividends. So, if the ratio is very high, it may be a cause for concern because the company may have trouble maintaining their dividend payment.
Before you start researching stocks based on these measurements, be sure that you compare stocks across industries. Industries vary quite a bit, so what might be a good-looking dividend stock in one industry could look completely different compared to a stock in another industry.
Do Your Research
Successful stock investing whether you’re looking for high dividends or not, takes considerable care and research.
Dividend investing is all about patience and leveraging the power of compounding returns, so it’s a good place to dip your toe into the water in terms of investing. Just remember that there’s always the possibility that your investments plummet in value.