There are two main ways of making money in the stock market. The first is buying low and selling high. The second is earning passive income through dividend payments. Dividend payments sound like a compelling idea but, as with other types of investments, there are a few things you need to know and keep in mind before buying dividend stocks. This guide is for beginners who want to understand dividend stocks and start investing in them.
Understanding Dividend Stocks
Stocks give you percentage ownership of the company issuing the stock. They are subdivided into shares that are then traded on stock exchanges. A dividend stock is any stock that pays out a certain amount every regular period which is typically every calendar or financial year.
Dividends are a share of the company’s profits or revenue depending on how the dividends are structured. In some cases, especially when a company is going through a financial hardship, the dividend is paid out of a loan borrowed by the company.
Because dividends are paid for each share owned, shareholders who hold more shares are paid a larger amount. Highly profitable companies also have larger dividend pools to share amongst their shareholders, and this becomes important when choosing a dividend stock to invest in.
Choosing Companies To Invest In
When choosing a dividend stock, long-term profitability is much more important than short-term profitability. A company might be doing well for a few quarters but end up doing terribly over a few years. Because of this, it is important to do thorough research on the earnings, profitability, and consistency of dividend payments of the companies whose stocks you would like to buy.
Dividend Yield
This is a critical metric when evaluating companies to invest in. It is the percentage of the share price that the company pays as the dividend. Let's say a company with shares priced at $50 pays out a dividend of $2 per share. The dividend yield would be 4% (2/50 * 100).
The average dividend yield is typically around 2% so a company with a dividend yield of between 2 and 6 percent is considered excellent. Their dividends provide safer returns compared to companies with low dividend yields.
Payout Ratio And Payout Growth
The payout ratio is the percentage of the earnings paid to shareholders as dividends. It is calculated by dividing the total dividend paid by the company’s net income. Any amount not paid as dividend is used by the company for internal expenses. These could include expansion, investments in equipment, and the like.
The payout growth is the average percentage increase in the dividend over a specific period, usually five or 10 years. A dividend payout growth rate of 5% to 9% is preferred.
Understanding the payout ratio helps you understand how liquid the company is and thus the probability of continuing dividends. The payout growth is crucial for helping you know whether the dividend will keep up with inflation.
Buying The Highest Dividend Yield Is Not Always Better
It might seem counterintuitive that the highest dividend yield stocks might not be the best. After all, you are trying to make as much money as possible, right? The problem is that the underlying business might be in trouble, and its share prices have fallen even as the dividend amount has remained the same.
Second, the dividend payout ratio might be so high that it threatens the business. With such a high dividend payout ratio, it might not have enough to reinvest and thus may not survive for long.
Understanding dividend stocks, and how to choose and invest in them can help you invest in a way that ensures guaranteed income in the future. Enough research and poring through data and company information will help you make the best decisions regarding the dividend stocks to buy.
