Dividends are payments a company distributes to share profits with its shareholders. There are different types of dividends – cash, stock, property, scrip, and liquidating dividends.
Dividends are regularly paid to stockholders, providing them with a constant source of income and are one of the ways investors can make returns from investing in a company.
Not all companies offer dividends as no law demands from companies to pay them with dividends typically paid by well-established businesses. Even though these companies want to keep the majority of their profits to fund their further business operations and fuel growth, a portion of that profit is distributed to shareholders through dividends.
Some companies prefer to regularly pay dividends to investors even when they do not turn significant profits.
Therefore, companies that pay dividends on a regular basis are referred to as dividend stocks. Many investors choose to back dividend-paying companies as they normally offer a stable source of income.
The dividend yield represents the amount of money a company pays to shareholders on an annual basis relative to its stock price.
In other words, it is a financial ratio (dividend/price) and is usually displayed as a percentage.
For example, if company X decides to pay an annual dividend of $10 and the current price per share is $100, the dividend yield is 10% (10/100).
If shares of the company surge, the dividend yield will fall. For instance, if company X pays a $10 dividend but shares rise from $100 to $200, that means the dividend yield is now 5% and not 10% (10/200). On the other hand, if the share price declines, the dividend yield will rise.
Dividend yields can be calculated using data from the company’s last full-year financial report, or the latest quarterly report.
Given that dividends are paid to stockholders on a quarterly basis, investors usually look at the last quarterly dividend and multiply it by four to calculate the annual dividend yield. But this can vary as well because some companies do not pay an equal quarterly dividend.
A common way to evaluate a dividend’s safety is to look at its payout ratio, which represents the share of its net income that is allocated for dividend payments. For instance, paying 100% or more of net income could negatively affect dividends.
The reason for this is that during challenging periods, earnings could plummet too much for the company to pay out dividends. This is why investors prefer to invest in companies that have payout ratios of 70-80% or less.
Put differently, the payout ratio represents dividends relative to the company’s earnings. Therefore, the payout ratio is usually a good indicator of a company’s dividend policy. For example, if a company has a payout ratio of 60%-80%, it means that it distributes more than half of its net income to shareholders.
Conversely, if the payout ratio is low (e.g. 10%-25%), it could indicate that the company wants to reinvest the majority of its income to fuel growth.
How to Choose Dividend Stocks
When picking what type of company to invest in, financial experts say that multiple metrics and factors should be considered. Some analysts argue that building a diversified portfolio of dividend stocks is a good approach.
Especially important is portfolio diversification with strategists advising investors to buy a handful of stocks, each in a different sector.
Strategists also believe that a solid payout ratio can bode well for the company’s stock in the long run as it suggests that the company’s leaders are committed to delivering consistent returns to shareholders, through dividends.
Of course, the crucial step is to find companies that pay dividends on a regular basis, as these are generally viewed as financially superior companies compared to the ones that don’t pay dividends.
Because of this, many investors prefer investing in dividend-paying companies as they believe these companies can remain stable in times of economic turmoil.
Furthermore, investors also like to support companies that hike dividends each year. Companies that have an established business are more likely to pay dividends as they do not have to reinvest a significant amount of their income. In contrast, technology companies are usually less likely to pay dividends as they constantly reinvest profits to fund further growth.
Companies across energy, financial services, healthcare, utilities, and basic materials sectors typically pay regular dividends because their profits are more consistent and predictable compared to other industries. These companies aim to maintain growth at a normal pace and maximize shareholder returns.
Also, companies that consistently pay dividends work hard to maintain that consistency because skipping dividends could raise concerns among their shareholders and be seen as a sign of a downturn, even when that is actually not the case.
On the other hand, high-growth companies and startups rarely pay dividends as they tend to spend the majority of their profits, or capital raised if they are still unprofitable, on research and development (R&D), growth, operational activities, and other investments that come with high costs.
Important Dividend Dates
Paying dividends is a process that follows a chronological order of events, each associated with a specific date. These events include the announcement date, ex-dividend date, record date, and payment date.
The announcement date is the day the company announces its dividend payments, which have to be approved by its investors.
The ex-dividend date is the day after which investors are no longer eligible to receive dividends. To give an example, if the ex-dividend date is set to March 25, investors who buy the stock on or after that date are not eligible to receive dividend payments.
The record date represents the cut-off date that determines which shareholders are eligible for the dividends. The record date usually comes one day after the ex-dividend date.
Finally, the company distributes dividends on the payment date, a day on which investors receive the funds.
Impact of Dividends on Share Price
Dividend payments are an irreversible process, which means that the money allocated for dividends permanently leaves the company’s books. Because of this, dividends tend to leave an impact on the company’s share price. Stocks usually rise on the announcement date and decline after the ex-dividend date.
The reason for this is that the announcement of dividend payments naturally urges investors to buy the stock because they know they will receive returns if they purchase the shares before the ex-dividend date. Due to this, investors are willing to pay a premium, sending the share price rising ahead of the ex-dividend date.
In most cases, the surge in share price is roughly equal to the amount of the declared dividend, but it can vary in different market conditions.
Similarly, the stock price often declines on the ex-dividend date by the amount equal to the dividend due to the fact that new investors are no longer eligible for dividend payments and are not willing to pay the premium price.
Just like cash dividends, the announcement of stock dividends also drives the share price. However, stock dividends result in an increase of the number of outstanding shares while the company’s value remains the same. This dilutes the book value per common share and thereby lowers the stock price.
There are different reasons why investors buy certain stocks. Some of them invest in stocks as it provides them with a consistent source of income, while others buy the stock close to the ex-dividend rate and sell them after the cut-off date, a common strategy that can deliver decent returns if executed properly.
Dividend Stock Example
A good example of a dividend stock is Pepsico. The company will soon join the Dividend King club. This means Pepsico has increased its shareholder dividends every year for at least the past 50 years.
PepsiCo announced a 7% dividend hike for this year – the landmark 50th time it has managed to do so. At the current stock price, Pepsico yields 2.63%. The company’s dividend payout ratio for 2021 was 67%.
Thanks to its strong dividend track record, Pepsico is one of the most popular dividend stocks in the market. This is one of the key reasons why Pepsico shares have performed well in recent months, despite the broader market selloff.
It is also important to note that Pepsico has robust financials thanks to its diversified business and diverse range of products. For 2021, the company has seen its sales increase 13% to $79.5 billion.
Dividend stocks represent a popular destination for investors to park their money as it provides them with a constant source of income, in addition to gains made by shares moving higher.
Companies in the sector of energy, financial services, healthcare, utilities, and basic materials are generally paying regular dividends while tech companies usually opt for buybacks or do not return capital to shareholders at all, instead, they prefer to invest in the company’s growth.
The announcement date, ex-dividend date, record date, and payment date are the most important dates for investors to focus on when researching dividend stocks.
Similarly, investors tend to analyze the dividend yield and payout ratio to determine which dividend stocks offer the best risk-reward.
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