Dividend investing is an excellent way to generate income, and also to grow capital. Companies that pay good dividends are often great long term investments, especially when the dividends are included in the return. While investors love to chase after the high-flying stocks with strong earnings growth, it’s the companies that generate cash that often turn out to be the best investments over time.
Companies that pay dividends are usually stable, profitable companies with a fairly predictable earnings stream. These types of companies also tend to have lower share price volatility and are therefore a good hedge against volatility within a portfolio.
The low volatility and steady income stream make dividend investing ideal for retirees who need income and stability rather than capital growth. But, dividend investing isn’t just for those who need the income stream. Dividend investing can produce very good capital growth over the long term with lower volatility than growth investing. The share prices are more stable than growth shares, and provided dividends are reinvested, the returns will compound over time. Many of the companies Warren Buffet invests in pay great dividends.
What types of companies pay good dividends
The companies with the best long-term dividend yield tend to be companies that are mature, yet still enjoying strong profit margins. These tend to be in industries with high barriers to entry like utilities and telecoms. Insurance companies also have strong, predictable cash flows, and can, therefore, pay good dividends. Real estate investment trusts are another type of company that pays dividends.
Payout ratio
The payout ratio is the percentage of a companies net income or profit that it pays out as a dividend. This will usually be between 30 and 60 percent. So a company that earns 50 cents per share and has a dividend payout ratio of 40% will pay a dividend of about 20 cents. The other 30 cents will be classified as retained earnings and will be reinvested in the business.
Dividend Yield Vs Dividend Growth
The obvious method to earn a good yield from shares is to look for a good dividend yield. But on often overlooked aspect is dividend growth. If a company is growing its earnings rapidly and has a sustainable dividend payout ratio, then the yield on your initial purchase price will increase quickly. Let’s say you buy a share for $10 and it’s paying a dividend of 20 cents. That’s a 2% dividend yield. But if that company is growing its earnings at 25% a year, that dividend will grow in line with earnings. After five years the dividend will be 61 cents or 6.1% on the initial purchase price.
DRIPS
Dividend Reinvestment Plans are offered by some companies and allow investors to automatically reinvest their dividends in the company’s shares. There are pros and cons to this and it really comes down to how disciplined you are. You may wish to use that money to rebalance your portfolio, rather than always putting it back into the same share. That’s fine if you are able to stick to the strategy. But if you are prone to making impulsive decisions, then a DRIP plan is a good idea.
Dividend Investing and Tax
The way dividends are taxed varies from country to country and often depends on how long an investment is held. Qualified dividends are those paid by companies held in a long term investing account, and are taxed at capital gains tax rate. If an investor receives dividends from a share held for a very short period, that dividend will be taxed at the investor’s income tax rate.
Avoiding the Pitfalls of Dividend Investing
Chasing Yield
Avoid yield traps where the dividend yield is high because the stock price has fallen. These are often companies that will have to cut their dividend in the near future. Look at the earning forecasts and dividend cover to see if the company can afford to pay its dividend going forward. Just because a company says it will pay dividends, or wants to pay dividends doesn’t mean it can. As a general rule investors should be wary of companies that pay more than 60% of their profits as a dividend.
Don’t ignore companies with low dividend yields and high dividend growth rates. If the dividend is growing rapidly you could soon be earning a massive yield on your original purchase price. Try to look at the likely yield over the next five to ten years.
Sustainability of Dividends
The best way to predict how reliable a company’s dividend payments will be is to look at how reliable their cash flows are. A company can only pay chunky dividends over time if they actually make real profits over time. If a company is funding dividends from debt, shareholder capital or, even worse, rights issues, they are going to run into trouble sooner or later.
Risk Management
Look at valuations too. If a stock is very expensive, a collapse in the share price could outweigh the dividend yield. There’s no point earning a 5% dividend yield when the share price falls 30%.
Dividend investing can also lead to concentration risk. The companies that pay dividends are often fairly similar. If they are in the same industry, they will be even more similar. Investors should try to diversify into different types of dividend paying companies. Try to avoid having all your capital in utilities, or small caps, or shares with very high yields.
Summary
In many ways dividend investing comes down to common sense. If companies can’t afford to pay dividends they won’t. So dividend investing really just comes down to finding the companies that can afford to keep paying a decent dividend and spreading your portfolio amongst those shares.