The following is a guest post by Andrew Sather from einvestingforbeginners.com. He’s been a self-taught investor since 2012 who’s passionate about educating those who need it the most, beginners.
It’s no secret that one of the best ways to earn a return on your investment in the stock market is to buy stocks with high dividends. An important mindset shift needs to occur in order to understand this power.
A typical investor might be more like a gambler, who buys something in the hope that the price goes up very quickly. The savvier investor looks at a stock as a cash flow generator, one that hopefully increases its cash payments over time even if that means sacrificing big short term gains.
The reason that the savvy investor’s strategy works so well is because of the way that compounding interest works.
The idea behind compounding interest is that when you make some money from an investment, you put that money back into your investment. Now the reinvested money will also make a return. If you reinvest this new money, your original investment is even bigger than the first two instances.
From there, the amount of new return generated from reinvestments accelerates immensely. What ends up happening is that the money grows exponentially instead of in a straight line.
The key is making a return and then reinvesting the money.
Now the problem with buying a stock without a dividend is that you can’t make a return without selling the stock. Then you have to find a new stock, and one that also goes up. If you continue a cycle like this, you have to be on the right side of the trade much more often.
Compare that to an investor who buys a dividend paying stock. Each yearly dividend is an immediate return in the shareholder’s pocket that he can use to buy more shares. Those new shares will also earn a dividend, and the cycle of compounding interest starts.
You can see that the non-dividend paying stock can at best grow in a straight line. That line could go up very quickly, but you’d have to time the sell point AND find a new and better investment. Whereas the dividend investor sees his money grow exponentially whether the stock moves up or down.
Consider also that a company that is doing well will increase their dividend payouts, so the return on investment increases from that as well. Combine that with dividend reinvestment (see also: DRIP), and now you have double forces of compound interest. Which just means you’re getting exponential growth on your exponential growth.
Where a dividend paying stock can give us great compounding interest, a stock with high dividends can make that compounding interest work even faster. When you start with a high yield, you immediately get more money to reinvest.
I hope you now have the right mindset. Here’s some warnings.
The Importance of Being Cautious
The problem with any type of investment is that it always carries some kind of risk. The biggest risk is the complete loss of your money, but a more common risk is losing some money.
Obviously, stocks move up and down constantly. To become a great investor, you must focus much more on limiting your losses instead of finding big winners. The reason is, again, another math problem.
Because of math, it takes much more money to make up a loss than it does to make that same amount of money without a loss. Let me show you with an example.
When you lose 50%, you have to double your money (100% return) just to break even. Think about that for a second.
It gets worse the more you lose. A 75% loss requires a 300% return to break even.
This math actually hurts my brain just thinking about it, but the numbers check out. Try it yourself if you know how to calculate returns.
Luckily for you, you don’t have to become an expert on stock market losers. That’s because I’ve already done extensive research on the topic. Without going too in depth in this one blog post, I basically analyzed the data from the 30 biggest bankruptcies of the 21st Century.
From that research, I came up with the following takeaways. This can be and should be used when buying any stock and especially for stocks with high dividends.
1. Check a company’s payout ratio
The payout ratio is simply the following equation: Dividend / EPS. When a company has a payout ratio over 1, it means that it is paying out more money than it is earning.
That’s obviously unsustainable, you need to earn money to spend money. The closer a company’s payout ratio gets to 1 the more risky the stock becomes.
A healthy payout ratio is anything below 0.5.
2. Check a company’s debt to equity ratio
This is a ratio that you can find on the balance sheet. Like all of the ratios discussed here, it can also be found on many financial websites like Google Finance.
Just like in personal finance, a company with too much debt will sink really fast. My bankruptcy research concluded that the higher a company’s debt to equity ratio, the greater the risk.
Debt to equity is calculated as: Total Liabilities / Shareholder’s Equity. The average debt to equity ratio in the stock market is generally around 1. As a stock gets much higher than this, the risk increases dramatically.
3. Check a company’s profitability
While the biggest correlation of a stock about to go bankrupt was a high debt to equity ratio, the most common indicator was negative annual earnings.
Logically, this check makes the most sense. The primary goal of any business should be to turn a profit. Investors buy a stock because they want a return on their investment.
A company failing the simplest yardstick of success is really failing their shareholders. Yes, some companies lose money to grow the business quicker. But many, many companies grow without this added risk.
4. Check a company’s valuations
Paying the right price for a stock is of the utmost importance after finding solid financials. You see, the stock market is run by people’s strongest emotions: fear and greed.
The result of this is that fear pushes stocks lower than they should go, and greed pushes them higher than they should go. You get bubbles and crashes.
Buying a great company is worthless if you buy at the top of a bubble. It’s impossible to know if you’re in a bubble until after it pops. That is, unless you know what the average prices are and should be.
That’s where valuations serve best. Since stocks are of all different kinds and sizes, you can’t simply compare average share price. You need to compare apples to apples, and that’s what valuations do.
Important valuations to learn are the right ranges for price to earnings ratio (P/E), price to sales ratio (P/S), price to book value (P/B) and price to cash (P/C). I have a free valuation training guide available to walk you through it step by step.
A simple checklist like this will eliminate many of the stocks that can wreak havoc on a portfolio. When you know what to watch out for, you can aggressively target stocks with high dividends while still keeping your strategy low risk. That sounds like a win-win situation to me.