If there is one area of the market that beginner investors should focus their attention on, it has to be dividend stocks. Dividends and the stocks that pay them have been a major source of the market’s long-term returns and have been one of the most sure-fire ways to build wealth over a lifetime.
But like many concepts in investing, understanding dividend stocks, how they function and just how they actually manage to generate long-term wealth can be a little daunting for beginners. After all, just like many other market concepts, there are plenty of moving parts when it comes to dividend investing.
However, with just a little leg work and basic knowledge, even beginning investors can turn into dividend stock pros.
Dividend Stocks: The Real Basics
When it comes to dividend stocks, investors need to remember just one word — cash.
Essentially, dividends are cash payments that companies make to their owners (shareholders) based on the number of shares that they hold.
Remember, when you by a stock, you are buying a piece of a business. That’s a fact that most investors — beginners or professionals — tend to forget. Most dividend-paying corporations give their owners a share of the profits by sending them a regular stream of cash payments every quarter. However, some send those payments monthly, semi-annually or even just once a year.
For example, soda and snack-food specialist PepsiCo, Inc. (NYSE:PEP) currently pays out 75 cents to its shareholders per quarter for every share of PEP stock they own. If you own 10 shares, PEP will send you a check for $7.50 every three months for doing nothing.
And that’s the really basic gist of dividends. Owners of a company get rewarded for their ownership by getting a portion of the firm’s profits on a regular basis.
Now, some firms will declare one-time special dividends in boom years, but the concept is the same. Own a piece of company and get a check for that ownership. It’s really one of the foundations to stock ownership. All things these publicly traded companies do come down to their ability to pay a dividend — now or in the future.
In order to get those checks, an investor must remember three important dates: declaration date, date of record and payment date.
The declaration date is the date when a company formally announces its intention to pay a dividend — usually through a press release. The key thing to pick out of the release is the date of record.
The date of record or “ex-dividend” date is the important one. Investors must own shares of the stock on or before this data in order to get the next payment. If PEP has an ex-dividend date of Sept. 14 and you buy it on Sept. 15, no dice … you won’t receive the next dividend payment.
For stocks you do own by the ex-dividend date, that payment will hit your account on the payment date.
Dividend Stocks: Slightly More Advanced Concepts
Now that we have the real basics of dividend stocks down, we talk a little turkey. And that turkey comes with a side of yield.
Every dividend stock has a so-called dividend yield. That’s the estimated dividend payout over the next 12 months divided by its current share price. This number — expressed as a percentage — can be thought of in the same vein as the “interest” you receive on a savings account or CD. Open a CD today and you can get an interest rate of 1.25%. Buy a share of XYZ stock right now and — with all things being equal — get a dividend of X%.
Using previously mentioned PEP as an example, if you were to buy a share right now, you’d get a dividend yield of 2.8%. That’s four payouts of 75 cents for a total of $3, dividend by Pepsi’s current $106 share price.
Another slightly more advanced concept with dividend stocks would be the payout ratio.
A stock’s payout ratio is the percentage of its profit that it hands back to investors as dividends versus the percent it keeps to fund future growth. A payout ratio of 50% means that for every dollar a firm earns in profits, it’ll hand back 50 cents to its investors as dividends.
Like dividend yield, it’s a moving target. But it can offer a look at what firms are doing to reward their shareholders and owners.
So Why Bother With Dividend Stocks?
So as beginning investor, why should you focus on dividend stocks rather than those retaining their cash for future growth?
You like being rich, right? Or being able to fund your future retirement?
Stocks that pay regular dividends simply have better returns than those that don’t.
Since 1930, dividends have accounted for nearly 42% of the total returns of the S&P 500. Without dividends, we would have significantly less in the way of total market return. Total return refers to the combination of capital gains and dividend payouts. Research by Ned Davis highlights this concept and why dividend stocks are great.
Between 1972 and 2014, dividend stocks have provided an average total return of over 9%. Those stocks that have been stingy with their cash and which didn’t pay anything returned far less. Dividend stocks even managed to beat the entire market by roughly 1.5% per year.
That 1.5% may not seem like much, but in reality when compounded over a multitude of years, it can make or break your retirement dreams.
These returns don’t even take into account the reinvestment of dividends. Normally, most brokerage firms will take those received cash dividends and place them in your sweep or cash account. As an investor, you can do whatever you want with them once they hit your account. A common option for dividend stocks is reinvest those dividends into more shares of the same firm, thereby getting more dividends during the next payout.
For long-term investors, this “boosts” payouts and returns even further.
Aside from the higher returns, dividends carry lucrative tax advantages and are taxed at lower rates than income. Getting paid for doing nothing and just owning stocks actually has a lower tax percentage than punching a clock and working 9-to-5 every day.
Dividend stocks also offer the ability to beat crippling inflation, as companies raise their payouts typically faster than changes to the consumer price index. In down markets, dividends can provide a cushion for portfolios too, as the stream of cash can soften the blow of share price declines.
Take A Look at Dividend Stocks
In the end, for a lot of people dividends are what stock investing is all about. And it’s worth it for beginning investors to familiarize themselves with the idea of dividends.
Aside from the instant income these payouts provide, higher long-term returns are the real benefit to investing in dividend stocks. While this article just touched on the basic concepts, in the end, it should give beginners enough info to get started.
As of this writing, Aaron Levitt did not hold a position in any of the aforementioned securities.