A Simple Introduction to Dividend Investing
So, you want to generate passive income from your stock portfolio, huh? Well, dividend investing might be right for you.
Dividend investing is a popular strategy for long-term investors with less of an appetite for market volatility. The reliability of this strategy comes from the fact that dividends are usually paid by large, blue-chip companies with more operational stability than their younger, faster-growing counterparts.
As a result, dividend stocks are less of a gamble than growth stocks. But, they’re also somewhat of a double-edged sword.
On one hand, these large-cap industry leaders don’t experience the same head-turning price appreciation as smaller companies. Sorry, but you won’t become an overnight millionaire buying dividend stocks.
On the bright side, dividend stocks do provide shareholders with a juicy dividend payment every quarter. When these dividends are reinvested the compounding effects can grow your portfolio at an impressive rate.
If you’re trying to decide which investment style is right for you, then keep reading.
In this article, I’ll breakdown everything you need to know to get started as a dividend investor.
Spoiler Summary
Dividends are a portion of corporate profits paid to shareholders.
Not all companies pay dividends & those that do can cut payments off when financial times get hard.
Key numbers to know when analyzing dividend-paying companies: Payout ratio, FCF per share, dividend growth rate.
Dividend investing is best for investors who want to create a passive income stream (i.e.: Retirees).
Dividend investing can also be a good strategy for less aggressive long-term investors.
What Are Dividends?
Let’s start at square one. To understand what dividends are we first have to discuss what stocks are.
What Are Stocks
When a company is brand new, someone has to put their neck on the line to fund the startup of that company. These brave souls are called “investors”.
In exchange for capital to fund the company’s initial growth efforts, investors receive an ownership stake in the company. This ownership comes in the form of stocks.
Stocks, also known as “shares”, entitle investors to share in the growth and the profits of the company they invested in.
As we all know, stocks can be bought and sold on the stock market. When you buy stocks from another investor, you are not actually providing new capital to the business. Instead, you are simply buying an ownership stake.
For a more thorough explanation of stocks read my article “What Are Stocks & How Do I Buy Them?”.
Dividends are a Benefit Of Stock Ownership
As a shareholder, you literally are an owner of the company.
This ownership status gives you some rights and benefits, the most relevant of which being the privilege to receive a dividend payment.
Dividends are a portion of earnings paid out by a company to the shareholders.
The keyword here is earnings - Which is stock market jargon for “net profit”.
Dividends are paid out of a company’s profits, not their revenue.
There’s a big difference.
Revenue vs Net Income
Revenue is the money that is made from selling products and services. It’s the first item listed at the top of the income statement, so revenue is often called the “Top Line”.
Revenue is money made before considering the cost of doing business.
At the risk of stating the obvious, it’s important we point out one minor detail - Running a business is not cheap!
That is why revenue and net income can be very different numbers.
From that top-line revenue number, business owners have to pay for;
Software
Real Estate
Machinery
Raw materials
Employee salaries
Research
Marketing
Interest on loans
… & of course taxes
The money remaining after expenses are paid is called “Net Income” - aka Profit or Earnings.
How Businesses Use Their Earnings
Like I mentioned, as a business owner, you are entitled to your fair share of the profits generated by your company.
However, if businesses paid out 100% of their profits as dividends then there would be no money left to continue growing the business.
Since you want to see your business grow, you’d better hope that the CEO is focused on reinvesting into the expansion of your enterprise.
Five Ways That Business Leaders Use Profits:
Capital Expenditures. This is the technical term for maintaining and upgrading older assets, purchasing new machinery, buying property, and opening new stores.
Pay Down Debt. Often companies will lighten the load of their liabilities to improve their financial position.
Repurchase Shares. When a company feels that their stock price is too low, they can “Buy Back” some of their own shares. This reduces the number of shares available to the public, which in turn makes each share more valuable (i.e.: Buy Backs make the stock price go up).
Acquire Other Business. Sometimes it’s easier to buy fully functional businesses that are already up and running rather than trying to expand into a new territory or scale-up from ground zero.
Pay Dividends. When there is no better use of capital, the best course of action is to return some of the profits back to the investors as a reward for their loyalty.
As you can see, in order to maintain regular dividend payments and still keep the business moving forward, corporations need to be making a LOT of money.
After looking at the list above of the different ways business leaders choose to spend their profits, you can begin to imagine why some companies pay a bigger dividend than others, while many companies pay no dividend at all.
Not Every Business Actually Makes Money
Believe it or not, many of the biggest businesses in the world are not profitable.
That’s part of the reason that not all businesses pay a dividend. They simply don’t make enough money, yet.
Here are some examples of companies with negative earnings as of November 2020:
NIO (Nio; Electric car company) -$44.10
DOCU (DocuSign; E-signature software) -$1.13
SPOT (Spotify; Music & podcast streaming service) -$7.63
ROKU (Roku; TV streaming platform) -$1.16
UBER (Uber; The world-famous ride-sharing company) -$4.05
CVNA (Carvana; E-Commerce platform for buying/selling cars) -$2.51
The list goes on…
None of these companies pay a dividend.
They are all young companies in the midst of a rapid growth phase. So, instead of dividing their profits among shareholders, they aggressively reinvest back into their businesses.
These growth stocks are the antithesis of what dividend investors are looking for. Right now, they have more potential than profit.
Fast-growing companies can be appealing to investors with a higher risk tolerance cuz there is a chance that their value will skyrocket when the business matures. However, investing in growth stocks is far from a sure thing.
Growth stocks are vulnerable to underachieving. If a young company falls victim to stiff competition, shifting industry trends, or regulatory headwinds, you can kiss your investment capital goodbye.
I digress.
Once a business can consistently generate a profit & grow its cash position year after year, then it can consider rewarding shareholders with a dividend.
A transition to paying dividends doesn’t usually happen until the company’s growth rate slows down and they shift their focus from expansion to profitability.
How Often Do Companies Pay A Dividend
Most businesses pay their dividend on a quarterly basis. One payment every 3 months.
So, instead of one $3 payment, you would more likely receive 4 payments of $0.75.
The exact payment schedule varies from one company to the next.
Take Starbucks (Ticker Symbol: SBUX) - They pay dividends in February, May, August & November.
On the other hand, Home Depot (Ticker Symbol: HD) - Pay a dividend in March, June, September & December.
If you want to know when a company pays its dividends, go to YahooFinance.com, search for the company, click “Historical Data”, then next to “Show” select “Dividends Only”, and hit apply… You will see the payment date of all of their past dividends.
Getting Your Share Of The Profit
Dividends are paid on a per-share basis.
The dollar amount that each share is entitled to receive each year is known as the “Dividend Rate”.
Calculating the dividend rate is actually pretty simple. In real life, public companies have hundreds of millions (if not billions) of shares and make billions of dollars in earnings, but we’ll use small numbers to keep things easy.
Assume that a corporation makes $1,000 in profit (net earnings).
From that $1,000 they may decide to pay out $300 in dividends to all of their shareholders.
The $300 dividend payment will be divided out evenly among all shares outstanding.
If a company has issued 10,000 shares, then each share will be entitled to receive a $0.03 dividend.
How To Identify The Best Dividend Stocks
In my early investing days, my due diligence process was a little less rigorous (to say the least). I’d look at a list of stocks and pick whichever companies paid the biggest dividends. The end.
Well, this obviously wasn’t the best way to build a portfolio.
As a serious investor, you need to understand which variables make one investment better or worse than the next.
Can a Dividend Be Too High?
There’s nothing like seeing that quarterly dividend payment hit your brokerage account. It’s a great feeling to own assets that generate passive income.
However, when a company is paying out too much of its earnings, beware. If hard times hit, your precious divided may be reduced or downright cut off.
Each quarter (13 weeks), the company will review its performance and decide if it can afford to pay its dividend as planned. If not, they will need to reduce or suspend their dividend.
Unless something seriously bad happens, the company will not reduce or suspend their dividend cuz any cut to the dividend would seriously upset investors.
Generally speaking, investors judge the stability and safety of dividend payments by comparing the dividend rate to the earnings per share. This ratio is known as the dividend payout ratio (Dividend / EPS = Payout Ratio).
Let’s continue from the example above and practice calculating the Dividend Payout Ratio. Here are the numbers;
Dividend Rate: $0.03
Earnings Per Share: $0.10 ($1,000 Earnings / 10,000 shares)
Therefore, DPR = 30%
A dividend payment is thought of as safe if the dividend payout ratio is 65% or lower.
If you want to be doubly sure that your dividend won’t be in jeopardy at the first sign of financial turbulence, there is another ratio you need to know.
Free Cash Flow Dividend Coverage Rate (AKA The FCF Payout Ratio)
When the dividend rate can be covered by the Free Cash Flow Per Share, then the dividend is thought to be in good shape.
Without getting too technical - Free cash flow is the actual money that a business makes after they cover the purchase and maintenance of all physical property (an expense known as “CapEx” or Capital Expenditures”).
🤓More specifically, Free Cash Flow = Net Operating Cash Flow - Capital Expenditures. FCF is found at the bottom of the Cash Flow Statement.
Free cash flow is a great measure of a business’ health because it is what you would actually see in the bank if you were running the business yourself.
Earnings, on the other hand, include adjustments for non-operating income and expenses as well as non-cash items such as depreciation. Non-cash expenses are how accountants (legally) manipulate financial statements to make businesses look more or less profitable, depending on their goals.
To be clear - Earnings don’t always tell a true story. Meanwhile, free cash flow cuts through all of the smoke and mirrors.
What Kind Of Businesses Pay The Biggest Dividends
Earlier, I mentioned that you want to aim for a DPR under 65%… Well, there are some exceptions to this guideline.
For example, utility companies.
Generally, utility companies have regional monopolies and very long-term service contracts. At the same time, these businesses are heavily regulated by the government, so they don’t have the freedom to raise their prices as they wish.
What does that mean for you as an investor?
A lack of competition and negligible variance in quarterly revenues allow utility companies the unique ability to reliably predict their future cash flows many years in advance.
This sector-specific combination of market dominance and limited growth potential allows utility companies to pay out an above-average dividend to their investors.
Utility companies pay big dividends because they literally have nothing better to do with the profits they generate.
You can find high-dividend companies in any sector of the economy, but here are specific industries to keep an eye on if you’re looking for primo dividend-paying stocks:
Apartment REITs (Real Estate Sector)
Phone & Internet Providers (Telecommunications Sector)
Banking (Financial Sector)
Manufacturing (Industrial Sector)
Grocery Stores (Consumer Staples Sector)
Electricity Companies (Utility Sector)
Mid Stream Infrastructure (Energy Sector)
There are a lot of strong dividend-paying companies in other sectors of the economy, but this is just a list to get you pointed in the right direction.
Dividend Aristocrats & Dividend Kings
Paying a steady dividend is no easy task. That’s why the best of the best dividend stocks are in a league of their own.
Any stock that has paid an increasing dividend for 25 years straight without suspending or reducing their payment is known as a “Dividend Aristocrat”.
Any stock that has paid an increasing dividend for 50 years straight without suspending or reducing their payment is known as a “Dividend King”.
As of 2020, there are only 30 Dividend Kings.
What Type Of Investor Should Use a Dividend Investing Strategy?
Investing is like cooking - There are different ways to do it well and each method has its own merits.
Keep in mind, though, no matter how good the recipe, you still need to learn how to cook well.
So, before you jump in with both feet, make sure that dividend investing’s strengths and weaknesses align with your goals, risk tolerance, time horizon, and comfort level.
Investing For Growth Without Too Much Volatility
Many, many people love the dividend investing strategy because the price swings of blue chip dividend-paying stocks are far less drastic than the volatile highs and lows of typical growth stocks.
This low volatility is due to the fact that (usually) only stable companies with a strong history of earnings pay a dividend. These companies tend to be industry leaders who’ve cornered a respectable share of their target market.
Price Appreciation And Dividend Growth Rates
If you’re a younger investor with plenty of time before you need to start tapping into your money, then you will want dividend stocks with the potential for capital appreciation and a strong dividend growth rate.
Some blue chip companies in expanding industries (i.e.: technology) pay a small dividend, but what they lack in dividends they make up in price appreciation.
A perfect example is Apple (ticker symbol: AAPL). According to GuruFocus, AAPL has a 5-year dividend growth rate of 10.4%. This is an indication that they’re committed to increasing the amount of capital flowing back into the hands of shareholders.
During the accumulation stage of your investing career, it would be wise to build a portfolio of stocks that have;
Low dividend payout ratios
High dividend growth rates, &
A strong competitive edge in an expanding industry.
Reinvesting Your Dividends
One last note on dividend growth investing…
To get the max benefit from dividends during the accumulation phase of your investing career you cannot (I repeat) cannot spend the dividends!
Instead, reinvest the dividends you receive and use them to acquire even more shares!
This can be set up automatically through something known as a DRIP (Dividend Reinvestment Program).
Most brokerages allow investors to set up a DRIP once they own enough shares of a company to buy 1 new share from their annual dividend payment.
To set up a DRIP with Questrade (my favourite Canadian brokerage) or to read up on the details, just visit this link.
How Industry Growth Rates Affect Dividends
If you are retired and looking to generate passive income from your nest egg, then you will want to identify stocks that pay a bigger dividend in order to optimize your portfolio for cash flow.
Since you need to spend your dividends, you will want to find companies with the highest sustainable dividend payments. These companies are going to be older, economic staples. Utility companies, banks, railways, manufacturers - Companies that have stood the test of time and are at low risk of going under.
As we’ve talked about above, these companies have all but taken over in their industry, so there is no more room for growth. A great example of this is Royal Bank (ticker symbol: RY).
Royal bank is the biggest bank in Canada and it has been in operations for over 150 years. Clearly, they have what it takes to navigate good times and bad times.
Royal Bank, like Apple is the leader in its industry.
They both have reasonable dividend payout ratios (AAPL 24.24% vs RY 54%)
They both have strong 5-year dividend growth rates (AAPL 10.4%, vs RY 7.20%)
At the same time, though, RY stock was only up 3.37% in the 12 months ending December 2020 compared to a 78.39% price jump for Apple over the same period of time.
Royal Bank (grey line) vs Apple Inc (blue line) 12-month return for the period of January 3rd, 2020 to December 31st, 2020.
This is an indication of the importance of picking companies in the right industry!
Both companies are industry leaders, but Apple is in a growing industry (tech) and Royal Bank is in a no-growth industry (traditional banking).
Dividend Cash Flow Strategies
So, if you’ve already built up your portfolio, you may want your nest egg to provide you with a secondary income stream.
RY has a 4.1% forward dividend yield. This means that for every $100,000 of RY you own, you get about $4,100 per year in dividends.
As you can see, retiring strictly on dividend income is not easy. You need to accumulate some serious capital during your working years and you also have to live a frugal lifestyle during your retirement.
In my honest opinion, this strategy is more “icing on the cake” rather than the main course.
Dividends are great to supplement your income, but you’ll need a million-dollar portfolio to live on dividends alone.
So, think of dividends as more of a supplement to your income rather than your primary source of spending money.
Final Word
Dividend investing is more laid-back than other high-growth focussed investing styles (cuz you never sell anything), but it does require that you spend a good amount of time researching stocks and maintaining an appropriate balance in your portfolio.
If you don’t love the idea of reading through annual reports and financial statements, then chances are dividend investing might not be for you.
On the flip side, if you enjoy analyzing businesses and searching for new opportunities to grow your capital, then you may get a kick out of building a dividend focussed portfolio.
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PS - If you’ve read this far - Thanks.
There is so much to cover on this topic that it was hard for me to cut it short! My hope is that this info will give you enough of a foundation to get started in the right direction. If you’re already a dividend investor, let me know in the comment section what dividend stocks you like.