A well constructed portfolio of high dividend paying stocks is a great foundation upon which to build a strategy to achieve financial independence. It is the passive income derived from such a portfolio which grants us our financial freedom. There is no point in being asset-rich if we are cash-flow poor. In this article I'll discuss how stock market beginners can get started with dividend investing.
What Are Dividends?
They are payments made out of earnings from a company to its shareholders. What is paid is the portion of profits which a company doesn't need in order to maintain and grow the business. It is the reward which shareholders receive in return for providing capital to the business. Along with capital gains, it is how an investor profits from buying shares.
The dividend yield is simply the amount of a company's annual dividend payments divided by the current share price expressed as a percentage. So a company paying an annual amount of $0.25 with a current share price of $5.00 has a yield of 5% (0.25 / 5.00 * 100). You don't really need to calculate this figure though because it is published in the financial pages of many newspapers, is available in the research section of many online stock brokers and can also be found on financial portals like Yahoo Finance.
Dividend yield is sometimes compared to the interest rate on a bank account. They are similar in that they both express the cash return an investor receives as a percentage of the original investment. However it is important to remember that a dividend is paid at the discretion of the company's management. Unlike a bank savings account, the board of directors may choose to lower or even stop payments to shareholders all together.
Another important concept in the world of dividend stocks is the DRP or dividend reinvestment plan. In simple terms a DRP is a mechanism whereby investors can elect to receive their payments in shares in lieu of cash. So instead of receiving a cash payment, the investor will receive an equivalent amount in shares. An investor who is entitled to a total of $500 in payment from a company whose shares are trading at $5.00 would instead receive 100 new shares.
DRP's have two main advantages. The investor receives the new shares without needing to pay any brokerage. This means the investor can grow the size of his or her holding at a lower cost than if he or she had bought the shares on the open market. The other advantage is that DRP's often operate at a discount to the current market price. So in the example above, if there was a 5% discount, the shares would be issued at $4.75 meaning the shareholder would receive 105 new shares.
DRP's are optional meaning that shareholders may choose not to participate and instead receive their payment in cash as normal. Not all companies operate DRP's.
An Income Oriented Investment Portfolio
Having read this far you could be forgiven for thinking that building the ideal income oriented investment portfolio should be a simple matter of buying a group of high dividend yield stocks then sitting back to watch the cash roll in. While in theory this is the case, in practise a serious share investor will need to dig a little deeper.
Dividend Payout Ratio
When buying shares for income, the last thing you want to see is for the level of income to fall, or even worse - to stop all together. For this reason it pays to look at the payout ratio. This ratio is simply the amount of dividends paid as a percentage of net profit. What we are looking for is a ratio of 100% or less. If the payout ratio is greater than 100% this means a company has paid out more than it earns and this can't continue for long. The dividend rate will need to fall - and so will your income.
So we've established that we'd like a company to earn at least as much money as it pays out but in order to create a stable income we also need to make sure those earnings are stable. For this reason we need to look at the company's history of profitability. We want to see net profit after tax being stable or preferably growing over a number of years.
We'd also like to see a history of paying dividends. Look back over the past 5 years and make sure the company is paying a regular dividend.
While you're checking on the dividend history, check to see whether the amount paid is rising each year. A rising dividend is good for two reasons. Firstly, it normally indicates a growing company in good financial shape. Secondly it means that your income will grow along with it.
Other Factors To Consider
While the income producing capability of the shares which make up your portfolio is important, there is yet more digging to do.
Before investing in shares I like to look at the financial strength of the company in question. This normally means evaluating the level of debt the business has (debt to equity ratio) and its ability to service the debt (interest cover). One thing I think we all leaned as a result of the global financial crisis is the consequences of borrowing too much. Enough said.
The other area I like to delve into before investing money is the performance of the company. The main thing I look at here is how efficiently the business utilises its capital (return on equity or return on invested capital) compared to others in the same industry. To me, the ability to sustain or increase returns on capital demonstrates a good business and increases the chances of capital growth also contributing to your overall investment return.
You've Got Some Homework To Do
I wont lie to you - stock market investing does require some work. Doing the research required to whittle down the list of investment opportunities to those with the best prospects takes time. But I think it's worth it. Watching the steady stream of passive income which results from dividend investing is rewarding in more ways than one.