Dividend Stock Investing - 7 Essential Concepts
By Brad Castro
Dividend Stock Investing is simply investing in dividend paying companies. But in order to determine if this style of investing is right for you, you need to know the essential terms and concepts of dividend investing. Here are 7 essential dividend investing concepts:
What is a dividend?
A dividend is a cash payment made by a company to its shareholders. It's essentially a portion of the company's profits returned to the company's owners (i.e. the shareholders).
How often are they paid?
For the vast majority of companies that pay dividends, distributions are quarterly. A company's Board of Directors sets the company's dividend policy (i.e. the dividend amounts and the payout dates).
When are they paid?
Each company will set its own dividend calendar, but there are certain important dates to be aware of: Dividend Declaration (when the company formerly announces its dividend policy for the next distribution cycle), Dividend Record (in order to be eligible to receive the dividend payout, you must be the shareholder of record on this date), Ex-Dividend (since it takes two business days for a stock transaction to "settle," ex-dividend date allows you to easily determine dividend eligibility - if you purchase shares on or after the ex-dividend date, you WILL NOT receive those quarterly dividends), and Dividend Payout (when a the shareholders of record actually receive their distribution).
How is a dividend yield calculated?
There are a couple of different important equations related to yields.
To determine the current yield of a stock, you simply take the annual dividend of a company and divide it by the current share price. For example, a company with a $0.25/share quarterly dividend equates to a $1.00/share annual dividend. If the stock is currently trading at $25/share, the current yield is 4.0% ($1 divided by $25).
Another important metric is known as effective yield or yield on cost. Since profitable and growing companies tend to raise their dividend payouts over time, this metric tracks what your personal dividend yield is based on your original investment rather than the current yield.
For example, if the company in the example above raised their quarterly payout from $0.25/share to $0.30, the annual dividend would increase from $1.00/share to $1.20/share. Assuming you initially purchased shares at the $25/share level when the stock was yielding 4.0%, once the dividend was raised your effective yield or yield on cost would increase to 4.8% ($1.20 divided by $25). Note: The current share price is irrelevant - your calculation is based on the original purchase price.
What is dividend growth investing?
Dividend growth investing is a long term investing approach that seeks to capitalize on the powerful effect that rising dividends can have on a portfolio. Many companies have a history of raising their dividends annually going back decades. If you invest in a company that increases its dividends by 10% a year, your own effective yield or yield on cost will double in about 7 years.
How and why do companies increase their distributions?
Simple - companies that raise their dividends do so because their earnings are increasing. If they were not increasingly profitable, they could not afford to do so. In fact, many investors take comfort in dividend increases, interpreting such announcements as a vote of confidence by the company.
One important metric related to this issue is the dividend payout ratio which is calculated by taking the distribution amount divided by the company's earnings. An excessively high ratio is most likely unsustainable and a red flag. It's also a good idea to compare the payout ratio of a company over time to identify any trends.
What is dividend reinvesting?
Dividend reinvesting is the act of using the income received from dividends to purchase more shares of the stock that paid the dividends in the first place. This can be a very powerful form of compounding your returns. The good news is that reinvestment is typically commission free, either directly through a company-sponsored DRIP (Dividend ReInvesting Program) or through an investor-friendly online brokerage.
Provided that an investor selects high quality companies, and doesn't overpay, dividend stock investing, coupled with dividend growth and dividend reinvestment, is a tried and true formula for long term investing success.
If you find this style of investing appealing, please visit the Great-Option-Trading-Strategies Dividend Stock Investing resource page for more information.
About The Author:
Brad Castro is a practitioner and promoter of Leveraged Investing, or option trading techniques and strategies designed to simulate successful value investing. Leveraged Investing has two objectives: to acquire stock in quality companies as cheaply as possible and then to squeeze more returns from those stocks once they've been acquired. Please visit http://www.great-option-trading-strategies.com for more information.