In this post, we’re going to talk about income or dividend investing. Dividend investing is when you buy a share of a stock or a fund not with the expectation of a price increase, but getting paid 4 times a year just for owning it.
If you’re like most people, you’re familiar with the stock market and its ability to create fortunes. Especially for those who know how to play it well and understand it correctly. You’ve probably also heard the phrase, “buy low, sell high.” But what if I told you that the price of a stock doesn’t matter as much as you think it does? Today we’re talking about a style called income or dividend investing. Dividend Investing is the practice of investing your money with the intention of maximizing dividend payments instead of looking for share price increases.
What is a dividend?
If you’re a total beginner and have no idea what a dividend is, that’s okay. A dividend is a portion of company profits that gets paid out to their shareholders 4 times a year. Say you own McDonald’s stock. Every year McDonald’s makes billions of dollars worldwide in profit. At the end of the year, they choose to do one of three things. Reinvest the profits back into the company and grow bigger, keep them in the bank as retained earnings, or pay them out to the shareholders as dividends.
The company will always make an announcement when they are paying a dividend and at what rate they’re paying. In their latest announcement, set for December of 2019, McDonald’s said that they will be paying a dividend of $1.25 per share. If you’re a shareholder, you will get a check for $1.25 for every share you own simply for owning the company stock.
What am I going to do with $1.25?
Granted no one is getting rich or even getting by on $1.25 paid out every quarter. Heck, you can’t even buy a Big Mac for that much. However, if you’ve been steadily buying Mcdonalds’ stock for years and amassed 20,000 shares in that time period, your check all of a sudden becomes worth $25,000. If all you did in life was own 20,000 McDonalds shares, you’d make $100,000 a year. Sounds cool right? Now let’s see how much those 20,000 shares cost. At the time of this writing, MCD stock is at $212 a share so that would cost about $4.24 million dollars to acquire. This is the reason why McDonald’s is not a good dividend investment stock. The dividend yield is too low.
What is the dividend yield?
The dividend yield is the percentage of a stock’s price that gets paid out as a dividend each year. It’s calculated by taking the annual dividend and dividing it by the stock price. To continue with the McDonald’s example, $1.25 paid 4 times a year pays out $5 over the course of a year. Take that $5 and divide it by the $212 stock price and you get a dividend yield of 2.3%. Not great in dividend yield terms. Dividend investors look to get a dividend yield in the neighborhood of 6% sometimes as high as 8%. A higher dividend yield allows you to create a larger income stream with a smaller amount of stock owned.
Why am I looking for a high dividend yield?
Let’s pretend that McDonald’s has a 6% dividend yield for a moment. That would equate to an annual dividend of $12.72 based on a $212 share price. Owning the same 20,000 shares would now pay you $255,000 a year. Sounds great, but there is still the issue of amassing the $4.24 million dollars required to generate it. But let’s see how it works another way.
Let’s keep the 6% dividend yield, 20,000 shares owned, and the $100,000 income from dividends constant. The amount of stock required to generate that income now drops to $1.66 million. That’s less than half than what was required before. Still a lot of money, but much more manageable than $4.24 million. This is because $5 is 6% of an $83.33 stock price. Most dividend investors will look for a company that has a high dividend yield. This allows them to buy bigger dividend checks with fewer shares of stock.
What companies have these kinds of dividend yields?
Companies that offer these high yields are typically older, more mature businesses that are not growing rapidly. Their prices are stable because they may not be in as much demand as a stock that is rapidly growing. They also pay out higher dividends because they’re already established and have most of their major expansion projects behind them. They’ve achieved profitability and for the most part, have stabilized and leveled off.
They’re usually found in the utility sector or the financial sector. For instance, let’s say ConEdison has built out all their power lines in New York City and has enough money coming in to plan for the replacement of the lines as they age. Rather than let their profits just sit in the bank, they pay it out as dividends to shareholders. On the other hand, It would be rare to see a silicon valley startup pay out a dividend. This is because they are using the profits generated to grow the company bigger.
I’ve seen a dividend ratio listed, is that the same as the dividend yield?
The short answer, no. The dividend ratio is the percentage of profit that is paid out as dividends. This differs from the yield because it is not related to the stock price. To keep the numbers easy, let’s say Company A makes $100 Million in profit this year. If they choose to pay out $50 Million in dividends, they have a 50% dividend ratio. A dividend ratio can sometimes be used to measure the maturity and health of a company. If a company has a high dividend ratio, it may be signaling that its growth period is over and they are looking to maintain their position in the market. If the dividend ratio is over 100% that means the company is paying more in dividends than its making and could have some rough times ahead. This number will not directly affect your income the way a dividend yield will.
Enter REITs. The ultimate in dividend investments.
A REIT (Real Estate Investment Trust) can be considered the ultimate dividend investment because, by law, they are required to pay out 90% or more of their profit as dividends. While companies can choose to cut or stop paying dividends at any time, REITS are guaranteed to pay out as long as they’re making money. REITs are formed when an investor group decides to either develop the property and sell or rent existing properties.
The properties owned by the trust generally have something in common (all commercial properties or all multi-family housing, etc.) kind of like ETF stocks all have something in common, and you can choose to invest in a specific type of real estate by choosing a specific type of REIT. It’s one of the best ways of becoming a landlord without having to deal with leaky toilets and bad tenants. I’ll post entirely on ETFs and REITs at another time.
How can dividend investing help me over traditional investing?
Dividend investing is a great alternative to traditional stock investing because it is a way to build your portfolio’s value while keeping things liquid. Over time, the stock market has historically returned about 7% a year on investments made. Generally speaking, if you invested $100, a year later, your portfolio would be worth $107. The $7 gain would come from the increase in the value of your stock.
In order to withdraw the $7 earnings, you’d have to sell stock to realize it. Compare that to buying $100 worth of stock with a 7% dividend yield, you would be paid the same $7 return in cash dividends. The dividend investor is also less concerned about the fluctuations in a stock’s price and may be less stressed when the market dips.
Who is dividend investing for?
Dividend investing is great for those who want to build up a truly passive income stream while keeping their assets liquid. It will take a lot of time and money to build up a sizable income stream, but when your money stays liquid, it can be converted to cash and moved elsewhere at any time. Compare this to real estate investing. You can’t convert a house to cash in 24 hours and move it elsewhere if you come across an opportunity elsewhere or the market sours.
It’s a great tool to help get your cash working for you. Like any equity investment, it carries the risk of losing your money which is why you should talk to a professional before investing. The only downside of dividend investing to traditional investing in my opinion is that dividends are taxed as ordinary income.
You don’t get the “capital gains” tax breaks that you get when you make money selling a stock for more than you paid for it. This is a reason why you should not just buy dividend stocks but some growth stocks as well.
To sum it up, dividend investing is something you should always consider because it keeps the money rolling in without tying your money up long term. with good habits, regular stock purchases, and enough time you can build up a dividend income stream that pays like a part-time job but with zero time commitment.