If a stock pays a $1 dividend and you can buy shares for $20 each through your stock broker, the stock is said to have a 5% dividend yield because that is the equivalent interest rate you are earning on your money [$1 dividend divided by $20 stock price = .05, or 5%]. That means that if you were to invest $1,000,000 into dividend stocks with 5% dividend yields, you would get $50,000 in the mail, or direct deposited into your bank account for that year.
The Basics of Dividend Investing
Good dividend investors look for several things in their favorite dividend stocks:
- High dividend yield: One idea that is popular among so-called value investors is to find stocks that have a dividend yield that is higher than the interest yield on United States Treasury bonds.
- High dividend coverage: This is an attempt to find out how "safe" a dividend is or whether it is in danger of being cut. Does a company earn profit from a wide variety of businesses or does all of the cash come from one business that might be vulnerable? How much of the profit is paid out as dividends? If a company earns $100 million and pays out $30 million in dividends, the dividend might by safer than if the company was paying out $90 million in dividends. In the latter case, if profits fell by 10%, there would be no cushion left for management to use! This is known as the "dividend payout ratio". As a very general rule, dividend investors don't like to see more than 60% of profits paid out as dividends because it might mean the company doesn't have a lot of growth opportunities left.
- Dividends that are "qualified": The rules are complicated so we won't get into them, but it is normally a bad idea to trade dividend stocks if you are after the dividend income. That is because stocks held for a short period of time don't get the benefit of low-dividend tax rates. The government wants to encourage people to be long-term investors so they often offer a lower dividend tax on stocks held at least a year or longer. Talk to your qualified accountant if you think this might be an issue for you.
What Types of Investors Prefer Dividend Investing?
Typically, dividend investing is popular among retirees and those who want to live on their money and are no longer able to work. Dividend investing is also particular popular among those who prefer solid and true, old-school blue chip stocks that are considered the "Great American Businesses" or, in today's world, the "Great Global Businesses". An example of a dividend stock might be Johnson & Johnson, which is one of the largest companies in history and has a dividend yield of more than 3.3%, or Philip Morris International, which has a dividend yield of more than 4.5% (in the interest of full disclosure, my family and I own both of these stocks in our own brokerage and retirement accounts, as well as those of our businesses).
