Retirement planning can be overwhelming. But, understanding some basic financial concepts can help you make smarter money decisions. This article will help you understand dividends. They can play a key role in your income portfolio.
Understanding Dividends
When an investor buys a stock, they own a fraction of the company. Because of this relationship, the company’s profits are shared with the shareholder. And dividends are a popular way to give profits back to shareholders.
Dividends are the portion of a company’s profits that they pay to investors.
Dividends are decided by the company’s board of directors. The size of the dividends depends upon the company’s performance. If the board of directors expects higher profits, they might declare higher dividends. Companies usually pay cash dividends, although there are other types.
Types of Dividends
- Cash Dividends
Most companies issue cash dividends. Cash dividends are paid out on a per share basis. Let’s say you own 1,000 shares and the company decides to pay a cash dividend of $2 per share. You would receive $2,000 for owning that company’s stock.
- Stock Dividends
Stock dividends are payments in the form of additional shares. Sometimes companies issue stock dividends because they need they need the cash for operating costs. Stock dividends are given as a percentage of existing shares. For example, if a company issues a 5% stock dividend and you own 100 shares, your total would become 105 shares.
Stock dividends are not taxable until they are sold. So, investors who do not immediately need capital may prefer stock dividends.
- Property Dividends
Property dividends are less common than cash or stock dividends. Property dividends can take many forms, such as real estate, products, equipment, software, or any other assets excluding cash and stocks.
Choosing the Right Dividend Stocks
Not all dividend stocks are created equal. Many companies pay dividends but some of the best ones show stable dividend growth from predictable profits. For example, the “Dividend Aristocrats” are companies in the S&P 500 that have increased their dividends annually for at least 25 years. There are only about 50 of them in the world.
Another useful list to find top dividend stocks is the “Dividend Achievers.” They’re companies that have increased their dividends annually for at least 10 years. And over 250 companies make this list. It’s a great place to start your search.
Look to invest in blue-chip, dividend companies. They’re nationally known and financially sound. They show up in many sectors but are common in: basic materials, oil and gas, banks, healthcare, and utilities. The right dividend stocks can offer income security during bear markets.
Dividend Payout Ratio
The dividend payout ratio is useful to measure dividend stocks. The ratio is the dividend per share divided by the net income per share. If a company earns $1 and pays a $0.50 dividend, the payout ratio is 50%. So if a stock has a low payout ratio, it might have room to increase its dividend. Also, if a stock is taking out debt to maintain its cash flow, it could be a sign of lower dividends in the future.
Dividend investors look for a payout ratio “sweet spot.” It is important to focus on more than just a high dividend yield… you need long-term sustainable growth. Our chief income strategist, Marc Lichtenfeld, likes to see a payout ratio below 75%. That way, if business declines, the company still has a buffer between its cash flow and its dividend payments. It won’t have to dip into savings, borrow money or cut the dividend.
Dividend Stocks for Retirement
Dividend companies can add steady income to your retirement portfolio. Most dividend companies pay their shareholders quarterly and they’re scheduled in advance. Companies can also issue non-recurring special dividends. For example, in 2004 Microsoft Corp. declared a special dividend of $3.00 per share. That was higher than its quarterly dividend of 8 to 16 cents per share.
Investors who build a portfolio of dividend stocks can collect a steady stream of income. If you space out your dividend payment dates, they can help cover your expenses throughout the year. This makes it a popular strategy for retirement.
The Benefits of Dividend Reinvestment Plans (DRIP)
A dividend reinvestment plan, also known as a DRIP, allows investors to reinvest their cash dividends into shares of the dividend-paying company. In other words, investors can buy more shares with their dividend payments.
Dividend reinvestment plans can compound your returns. Here’s how it works: by reinvesting your dividends, you buy more shares. With more shares, you’d receive more dividend income. You could then buy more shares, which would generate even more dividend income… Dividend reinvestment plans are a powerful method for growing your wealth.
According to NerdWallet’s analysis of data, The S&P 500’s average return from 1928 through 2017 was about 7.6%. But, if all dividends had been reinvested, it would have been about 11.5%. That proves DRIPs increase your wealth over the long-term regardless of economic downturns.
In most cases, DRIPs allow shareholders to get shares commission-free. And in some cases, the company will offer shares at a discount to the current share price.
To see the value of your future investments with and without reinvesting dividends, check out our dividend reinvestment calculator.
Compound Interest
Compound interest is a key concept to understanding dividend reinvestment plans. Albert Einstein is noted for saying that it is “the most powerful force in the universe.” And Warren Buffet called compound interest one of the three biggest factors contributing to his wealth. It is crucial to growing your assets and preparing for retirement. To learn more about compound interest, check out our compound interest calculator.
The Goal of Dividend Investing
Dividend investing is the strategy of creating a portfolio primarily comprised of dividend-paying stocks. As opposed to a growth investing strategy—which focuses on up-and-coming companies with a rising share price—dividend investing focuses on long-established companies with an excellent track record of financial health.
Dividend investing, at its core, is a strategy with two parts and requires a long time horizon to truly be effective. The longer you can play out a dividend investing strategy, the more fruitful it’ll be!
For the first part of the strategy, a person will spend the majority of their investing career diligently investing money in dividend-paying stocks, opting to reinvest any dividends paid back into more shares. Over time, through the magic of compounding reinvestments, the number of shares owned will increase at a dramatic rate.
The second part of the strategy simply involves turning off dividend reinvesting when a person reaches retirement age. Instead of going towards the cost of new shares, dividends paid will go directly to the stock owner as a form of income.
If you have any questions about dividends, please comment below.
Good investing,
Peter
