A company has a number of options for the profits it makes through its operations. It can retain the money within the business, perhaps using it for expansion, or it can invest in the business by paying down debt or conducting a share repurchase program. It can also elect to pay its profits, or part of them, to its shareholders by way of a dividend.
For some investors, living off dividends will be the aim of their investment strategy. Often these investors will invest their money in high yielding, dividend growth stocks.
When it wants to pay a dividend, a company will announce this on what is called the declaration date. Once the dividend has been declared, the company is committed to paying that dividend, and it will be shown as a liability in its accounts. At the time of this declaration, the company will also announce a date of record and a payment date.
The date of record is the date on which all investors who are shareholders will qualify to receive the dividend. It is also referred to as the ex-dividend date, because anyone who becomes a shareholder after this date will be buying shares excluding the right to receive the upcoming dividend. The ex-dividend date is usually four days before the payment date, which is the day on which cash dividends will be given to shareholders entitled to them.
The dividend yield of a stock is the percentage of its share price that is paid by way of a dividend. For example, if the annual dividend paid by ABC is $1 and its share price is $40, then its dividend yield is 2.5% (1/40 x 100). Most companies pay a dividend once each quarter, but the dividend yield is calculated on an annual basis – that is the quarterly dividends are added together before the yield calculation is made. The dividend yield is used to compare the income return of different stocks, and against other income producing investments.
Types of dividend
Companies can pay dividends in a variety of ways, but the two most common are cash dividends and stock dividends. Cash dividends are paid out of the profits and cash reserves of the company, and stock dividends are paid by creating extra shares and distributing them as a dividend.
Often the terms of a stock dividend, if offered as an alternative to cash, are slightly enhanced: when stock is given as the dividend, the company gets to keep its cash in the bank for other uses. Stock dividends will have the effect of diluting existing shares and lowering the share price (more shares in existence but the company’s overall value remains the same).
Just like interest on cash in a savings account, dividends are taxed at a person’s individual tax rate. Dividend investors, therefore, must be aware of this, as it has a detrimental effect on returns. This is the reason that some investors prefer to invest in companies that retain their profit for business expansion and not pay dividends: capital gains are taxed differently and according to the length of time an investment is held.
Some people argue that the dividend tax is a form of double taxation, as profits have already been taxed at the corporate level and dividends are paid out of the profit made.
High income stocks
An investor wanting to create a portfolio of income generating will probably look at those stocks that pay a high yield.
The investor will also be concerned with dividend record, and stability of payment: he will want to see that the yield has been at least maintained with increasing dividends over a long period of time. While history doesn’t necessarily show what the future will be, a company that has a long history of rewarding shareholders by a keen dividend policy is unlikely to change that policy overnight.
The investor will also look at the business on an investment valuation basis, taking note of the potential profitability and revenue stream of the company. Receiving a high dividend yield is great, but if the business may see profits tumble over the next couple of years it is possible that those dividends could melt away.
Although dividends are paid from earnings, a dividend can still be paid even if a company has made a loss. This is because the company can pay dividends from retained profits and cash flow. A dividend paying company may do this if it has a bad year for exceptional reasons, for example, a one of litigation payment. Similarly, a company that has an unusually good year of profitability may not raise the dividend because of the fear of having to reduce it when profitability returns to normal.
Stocks that benefit from good cash flow and a steady income stream often pay better than average dividends to shareholders. Such stocks tend to have a lower volatility than growth stocks, and often even lower than the broader market. Future growth potential may be limited, and so profits are not needed by the company for expansionary purposes: these excess profits are distributed to shareholders instead.
Typically, stocks in the sectors of energy, utilities, natural resources, and financial institutions, will offer high dividend yields.
Also, investors in real estate companies, known as REITS (real estate investment trusts), benefit from very strong dividends. This is because by law REITS must distribute 90% of their profits as a dividend to shareholders. Often REIT dividend yields are around 10%.
Selecting high income stocks
When building a portfolio of stocks that pay a high dividend, investors should conduct proper research and due diligence:
- Just because the yield is high, does not mean the stock is a buy;
- Take note of the business the company is in, and the outlook for that industry;
- Consider the history of dividend payments: companies with a long history of strong dividend payments are more likely to continue to pay them;
- Pay attention to debt and cash flow levels;
- Even if you don’t want or need income, reinvesting dividends, perhaps by a dividend reinvestment program (DRIP), could improve returns because of the compounding effect.
Investors look at the high income sector and dividend paying stocks not only for income generation, but also because of the relative price stability of the shares in comparison to the broader market.
Those that don’t need or want income immediately will seek to increase capital value by a dividend reinvestment strategy, taking stock dividends or buying more shares with the cash dividend. In this way it is hoped that the value of the investment will grow exponentially until such time that income is required.