Basics of Dividends

 Basics of Dividends

Dividend investing is a popular and profitable strategy that involves buying and holding stocks that pay regular dividends to shareholders. Dividends are payments that companies make to distribute a portion of their earnings to their investors. By investing in dividend-paying stocks, you can create a passive income stream that grows over time and benefits from the power of compounding.

But how do you choose the best dividend stocks and what are the secrets of successful dividend investing? In this blog post, we will explore some of the key factors and tips that can help you build a solid dividend portfolio that generates consistent and growing income.

What is dividend yield and why does it matter?

One of the most important metrics to look at when evaluating dividend stocks is the dividend yield. The dividend yield is the annual dividend per share divided by the current share price, expressed as a percentage. For example, if a stock pays $2 per share in dividends and trades at $100 per share, its dividend yield is 2%.

The dividend yield tells you how much income you can expect to receive from a stock relative to its price. It also reflects the market’s perception of the company’s financial strength, growth prospects, and risk profile. Generally, a higher dividend yield means that the stock is undervalued, has a strong cash flow, and offers a high return on investment. However, a very high dividend yield can also indicate that the stock is overvalued, has a weak cash flow, or faces significant challenges that may jeopardize its ability to sustain or grow its dividend.

Therefore, when choosing dividend stocks, you should not only look at the absolute dividend yield, but also compare it with the industry average, the historical average, and the growth rate. A good rule of thumb is to look for stocks that have a dividend yield above the market average (currently around 1.5% for the S&P 500), but below 6%, which is considered the upper limit for sustainable dividends. You should also look for stocks that have a consistent or increasing dividend yield over time, which indicates that the company is able to maintain or raise its dividend even when its share price fluctuates.

What is dividend growth and why does it matter?

Another key factor to consider when investing in dividend stocks is the dividend growth rate. The dividend growth rate is the percentage by which a company increases its dividend per share over a certain period of time, usually annually or quarterly. For example, if a company pays $1 per share in dividends in year one and $1.1 per share in year two, its annual dividend growth rate is 10%.

The dividend growth rate tells you how fast a company is increasing its payout to shareholders and how much your income will grow over time. It also reflects the company’s confidence in its future earnings, competitive advantage, and ability to generate free cash flow. Generally, a higher dividend growth rate means that the company has a strong and growing business, a loyal customer base, and a competitive edge in its industry. It also means that the company is committed to rewarding its shareholders and increasing their wealth.

Therefore, when choosing dividend stocks, you should look for stocks that have a high and consistent dividend growth rate over time. A good rule of thumb is to look for stocks that have an average annual dividend growth rate of at least 10% over the past five years. You should also look for stocks that have a payout ratio below 60%, which is the percentage of earnings that a company pays out as dividends. A lower payout ratio means that the company has enough room to increase its dividend in the future without compromising its financial stability.

What are some examples of good dividend stocks?

To illustrate how to apply these criteria in practice, let us look at some examples of good dividend stocks that meet these standards:

• Microsoft (MSFT): Microsoft is one of the largest and most successful technology companies in the world, with dominant positions in software, cloud computing, gaming, and hardware. Microsoft pays a quarterly dividend of $0.62 per share, which translates to an annual dividend yield of 0.85%. While this may seem low compared to other stocks, Microsoft has increased its dividend by an average of 11% per year over the past five years, which shows its strong commitment to shareholder value. Microsoft also has a low payout ratio of 30%, which means that it can easily afford to raise its dividend further without hurting its growth potential.

• Johnson & Johnson (JNJ): Johnson & Johnson is one of the largest and most diversified healthcare companies in the world, with leading positions in pharmaceuticals, medical devices, and consumer products. Johnson & Johnson pays a quarterly dividend of $1.12 per share, which translates to an annual dividend yield of 2.48%. Johnson & Johnson has increased its dividend for 59 consecutive years, making it one of the longest-running dividend aristocrats in history. Johnson & Johnson also has a moderate payout ratio of 50%, which means that it can maintain its dividend even during challenging times.

• Coca-Cola (KO): Coca-Cola is one of the most iconic and recognizable brands in the world, with a dominant position in the global beverage industry. Coca-Cola pays a quarterly dividend of $0.42 per share, which translates to an annual dividend yield of 2.97%. Coca-Cola has increased its dividend for 59 consecutive years, making it another dividend aristocrat with a proven track record. Coca-Cola also has a reasonable payout ratio of 77%, which means that it can sustain its dividend while investing in new products and markets.

Conclusion

Dividend investing is a powerful and rewarding strategy that can help you generate passive income, grow your wealth, and beat the market over time. By choosing stocks that have a high and growing dividend yield, a high and consistent dividend growth rate, and a low and sustainable payout ratio, you can build a solid dividend portfolio that will serve you well for years to come.

~Isha Tatar