FAQ on Dividend Stocks
This is a Frequently Asked Questions (FAQ) page on dividend stocks.
What are Stocks?
Stocks, or equities are an ownership interest, or share of a company. While these shares could be for a company which is listed on a publicly traded market, they could also be for a private company (in this FAQ we will only be discussing publicly traded stocks). These shares give the holder of the shares voting rights and a proportion of the company’s dividends and earnings growth. It also gives the shareholder the ability to benefit from the fortunes of the company both good and bad via its share price. If the company does well the share price should go up and if the company experiences a rough period, the price of the shares could drop.
What is a Dividend?
A dividend is a distribution made by a company to its shareholders. These dividends are typically made in cash, but occasionally they can be made in stock. Dividends are typically paid out quarterly, however they can also be made annually, semi-annually, or monthly. Some companies also pay special dividends, which are dividends at the discretion of the management.
What are Dividend Stocks?
Dividend stocks are typically characterized as stocks which pay out dividends. When a company pays out dividends it is entirely a voluntary decision by its management. Not all stocks have made the decision to pay out a dividend, but stocks that do and have a history of paying out dividends fall into this category. These stocks are generally characterized as being conservative and less risky. While we feel this is an overly general characterization of dividend stocks, the numbers do support this thesis.
What is Dividend Yield?
Dividend yield is the percentage yield an investor would receive from a company if they held the shares for an entire year. The Dividend yield equals the annual dividends paid out to a shareholder divided by the share price of the company stock. The dividend yield shows you what your return would be if you bought the stock at today’s prices. This is a useful measurement if you are looking to invest for yield.
What is Dividend Reinvestment?
Dividend reinvestment is when an investor takes the cash dividend which they receive from the company and reinvest it back into shares of the company. This produces a multiplier effect over time by continuing to hold the shares. Read this article, This one secret could significantly increase the returns from your dividend stocks with one quick phone call , for details as to how the process works. Essentially it works in the same way that compound interest works, but it has some added benefits. Here is a graph illustrating the principal of how it works:
Dividend Reinvestment Plan (DRIPs)
The Dividend Reinvestment Plan or Dividend Reinvestment Program (DRIP) is a program sponsored by the company which issues the dividends. This program has been available to shareholders for decades via the sponsoring company, but it is not widely advertised. The DRIP allows the existing shareholders to use the dividends that are paid out to them to purchase additional shares of the company. This is typically done automatically and without incurring a commission for the shares making it both convenient and cost effective.
If you want to sign up for the company’s DRIP, there are two different ways to sign up to reinvest your shares, depending on how the shares are held.
- Shares held in physical certificate form- If you hold your company shares in physical certificate form, you should contact the company’s transfer agent to find out how to enroll in the company’s dividend reinvestment program.
- Shares held at a broker dealer- If your shares are held at an account with a broker dealer, then you should contact your broker to find out if they offer a dividend reinvestment program. This is a relatively new service with most broker dealers, so your broker may not have this available yet. If they don’t offer it, then you can contact us, we can help you find a broker that can provide this option.
Dividend Growth Stocks
The phrase “Dividend Growth Stocks” is sort of an oxymoron in that stocks are typically characterized as either growth stocks or value stocks. Dividend stocks typically qualify as value stocks. There is no agreed upon definition for either growth stocks or value stocks other than what you can expect from them. You should expect growth in the share price from growth stocks, and not a dividend. Value stocks are more likely to have a dividend, and investors should not expect better than average growth from them. Growth stocks typically have a higher PE ratio. This is one of the better ways to tell if a stock is a growth or value stock.
We like the term Dividend Growth Stocks because it idealizes what every investor should want in their investment. Both growth and a distribution of cash flow. However when a company distributes its cash flow to investors then it doesn’t have that cash to reinvest back into the company for further growth. This is the conflict in the phrase.
That being said, we are always looking for investments with these characteristics. There are a number of stocks which are considered value stocks, pay out dividends, buy back shares, and they still have tremendous growth. These companies are few and few between, but they do exist.
Safe Dividend Stocks
Dividend stocks tend to have characteristics which make them lower risk than growth stocks. These are businesses which have entered a mature part of the cycle in their section of the economy, have consistent and predictable cash flow generated from that business, and are usually shareholder friendly by distributing dividends and buying back shares. These characteristics frequently put companies into the value stock category.
However, it is not wise to characterize a company as low risk based solely on their paying a dividend. There are many companies which pay a dividend, yet might not be considered low risk. The only way to determine the risk of the company as an investment is to conduct a thorough due diligence process prior to any investment.
What are Dividend Aristocrats?
Dividend Aristocrats are companies which have both paid and increased their dividends for 25 years in a row. This is an exclusive club. Only 107 names were on this list as of the end of 2013. While this list is a good starting point in looking for consistent dividend payers, there are companies being added and subtracted from this list each year. So it is important to do more extensive due diligence than just looking at dividend yields.
One thing this list of Dividend Aristocrats does is it shows which companies have a self-imposed moral obligation to continue to pay and increase the company’s dividends. The choice to pay dividends to shareholders is entirely a voluntary decision on the part of the company management. If conditions get challenging, the company can cut or eliminate the dividend for a period of time. If conditions improve, the company can initiate or increase the dividends paid to shareholders. However, when a company on the dividend aristocrats list pays dividends for 25+ years, shareholders expect to receive these dividends, and they expect those dividends to increase. This is a moral obligation that the company imposed on itself by providing consistent dividends.
When a company increases its dividends for a long period of time, shareholders become accustomed to receiving those dividends, so if a company on the dividend aristocrats list stops or reduces its dividend, shareholders will most likely sell their shares of the stock and cause the price of the shares to fall. Since management does not want the price of their stock to fall, they continue to pay out dividends, even if it is financially painful for them temporarily. This moral obligation is a good thing to have as a shareholder, it keeps the management on track of being shareholder friendly.
What should you look for when searching for solid consistent paying dividend stocks?
Our process at Innovative Advisory Group of searching for high quality dividend stocks is very specific. While we will not disclose our special sauce of how we select stocks for our portfolios, we can give you some insight into areas that you might want to look at when choosing a dividend stock for your portfolio.
Strong Balance Sheet
We look for companies that can weather both good and bad economic conditions. Despite the desire to avoid recessions at all costs, they are a natural part of any economic cycle. During these challenging times, you want to make sure the company you have invested in is not overly leveraged and has strong assets. Companies which are overly leveraged can get into trouble if they misjudge the economic cycles. A strong balance sheet is one way to make sure your investment is on sound footing.
Consistent Cash Flow
Consistent cash flow is important to any investment we consider for portfolios. Finding a company which has consistent cash flows should provide you some insight into their ability to continue to pay out the dividends.
Consistent Dividend History
A consistent dividend history is a good starting point for finding dividend stocks for your portfolio. What makes a good dividend stock is stability of the company and predictability of the dividend. While anything can happen, if you can minimize the risk of the company cutting their dividend by relying on the moral obligation of the company to pay out that dividend, then you can consider your dividend less risky.
Dividend Payout Ratio
Dividend payout ratio is the dividends paid out to shareholders divided by the net income. In simple terms this means, how much of the company’s net income is going to pay out the dividends. If the dividend payout ratio is low, then shareholders don’t have much to worry about with the company cutting the dividends due to cash flow problems. However if the dividend payout ratio is high (>75%), then shareholders have to be cautious about the ability of the company to continue to pay out the dividends at the same or increasing rate. Some companies such as REITs or MLPs, consistently have a high payout ratio due to certain tax requirements, so it is not always a good indicator of the company’s strength of its ability to pay dividends. However it is important to consider this metric if you are looking for dividend stocks to consistently deliver income.
The dividend yield is the percentage of income via dividends returned annually based on the purchase price of the stock. This is not a deciding factor in which company we choose to invest in, but all else being equal, a company paying a 4% dividend yield is better than one paying a 1% dividend yield. If you decide to take advantage of our secrets to amplify your returns via dividends stocks, then eventually the difference in dividend yield will be less important than actually being invested in these stocks.
Strong management is an important factor in any investment regardless if it is a dividend stock or otherwise. There isn’t much to say here about it other than it is important.
Moral Obligation to pay Dividends
As discussed above, a moral obligation to pay dividends is an important component to dividend stocks in that people rely on the dividend being stable, if the management team cannot continue to pay the same or more dividends each year, then the stock will most likely endure some unfavorable pricing for existing shareholders. It is especially important for dividend stocks to be consistent with their dividends. A moral obligation to pay dividends ensures this consistency and it becomes stronger each year as the years pass.
Why should you consider investing in Dividend Stocks?
Innovative Advisory Group’s portfolio management strategy is generally comprised of investments that produce consistent cash flow. Typically this free cash flow from stocks is distributed to investors as a way to be shareholder friendly. This is not always the case, but when a company has extra cash that it does not need for its operations, capital expenditures, or mergers and acquisitions, it can pursue more shareholder friendly methods of utilizing the cash, such as: buying back shares, paying down debt, and distributing dividends.
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