By If you launched a business, you would expect to invest a certain amount today, produce income every year, cover expenses, and then pocket the profits, right?
Investing in stocks is the same concept. When you buy stock, you are purchasing a small portion of a huge corporation. The company spends money to make money and hopes to turn a profit by the end of the year. Part of these earnings is distributed to investors in the form of dividends.
For many investors, dividends are extremely crucial. Some investors rely on them not only to survive, but also to evaluate the overall value of the company. Dividend investing is an investment strategy that focuses on dividends. Here’s everything you need to know about it.
Your Dividend Investing Guide
To understand why dividends are so important, we must first understand how they are generated. Dividends are based on the company’s free cash flow. As the name implies, free cash flow is cash that remains in the organisation and does not need to be used.
The majority of publicly traded corporations generate a cash profit at the conclusion of the fiscal year. Management then decides to reinvest some of this cash back into the firm. Some of the funds are used to purchase new property and equipment, expand operations, or repay loans. After all of this is completed, the remaining funds are either placed in a bank account or distributed to shareholders. After all, the company’s owners (shareholders) deserve to keep the remaining cash.
The Advantages
It’s difficult to argue that tangible monetary returns are desirable. Take Google (NASDAQ: GOOG) as an example. The tech titan reinvests all of its free cash flow back into the company and does not pay dividends. If you acquire Google shares, you will receive an annual report stating that the company is performing well and making a solid profit. But you won’t get any of that money until you sell the shares.
Coca-Cola Co. (KO) made $1.37 per share in 2016 and paid out $1.05 in dividends per share throughout the year. This means the corporation paid out roughly 77% of its earnings. In fact, for the past half-century (54 years), KO has paid an annual dividend that has steadily increased. It shows no indications of slowing down.
Consistent and growing dividends are a strong indicator of the company’s stability and maturity. Companies are hesitant to reduce or eliminate dividends, thus their payout methods are often stable. A healthy yield can potentially beat the fixed rate of interest that investors can get from savings accounts. AT&T (T), for example, pays a dividend yield of approximately 5%, which is significantly greater than the current return of 2.3% on US 10-year Treasury notes. A high dividend-paying stock can act as both an equity and a fixed income asset. This is ideal for income-seeking investors.
The Disadvantages
Dividends aren’t a surefire method to become wealthy. They have some drawbacks that must be considered before investing in dividend-paying companies.
If you look closely, several of the highest dividend payers are slow-growing, mature companies. These high dividend firms do not expect to develop substantially over time. They typically operate in stagnant industries with limited stock price appreciation.
Furthermore, the stock price could reduce the dividend yield. If a stock pays 5% in dividends but the price decreases 5% that year, your gains are gone. Companies can also choose to reduce or stop paying dividends if conditions change. When the price of oil plummeted in 2014, many energy corporations reduced their dividend payments. Similarly, new management could adjust the dividend payout schedule.
Finally, dividend tax rates are highly variable. Right now, the tax rate is determined by the investor’s income and whether the dividends are qualified. However, this may alter over time, affecting your performance.
The Strategy
Investing, like starting a business, needs a high level of discipline. You must plan ahead of time and be determined to stick to a solid approach.
Dividend investing is a relatively easy three-step technique.
Step 1: Find great dividend stocks
An excellent dividend stock is one with a high yield and the financial resources to continue paying dividends. Take the time to look through the S&P 500 Dividend Aristocrats Index for firms that yield more than Treasury Bonds and have enough headroom to continue paying dividends in the long term.
Step 2: Value them using DDM
After you’ve limited the selection down to a few stocks, you must purchase them at a lower price than their worth. Estimate how much the corporation is anticipated to pay in dividends over time and discount these payments to present value. This present value represents the stock’s inherent value, and you should strive to buy it for less. This is known as the Dividend Discount Model.
Step 3: Review regularly.
Once you’ve built a diverse dividend portfolio, you should assess it on a regular basis to look for changes in valuation, dividend policy, and earnings power. It’s like a health check for your portfolio.
Verdict
Dividend investing is a straightforward strategy that really applies common sense and the power of compounding to make you wealthy. If you apply the three-step strategy mentioned above, you’ll end up with a portfolio filled with excellent companies that regularly give back hard cash to shareholders. Don’t expect these companies to grow rapidly or stun the world with a hot innovation. But if you have the patience to hold them for the long term, they could provide some tremendous returns.
