BEST Beginners Dividends Guide
Updated: Nov 1, 2022
There are people in this world who live off dividends.
These people are one of those who don't even need to do anything except collect money from the companies they invested in.
Imagine that, just doing whatever you want and not having to worry about your finances at all and the companies will automatically send you money.
How would that be?
Because of this, dividends are one of the best investment tools that can help a person, especially someone in their 20s, to map out their retirement. It seems far away but the truth is that the longer your money can stay invested in the markets, the greater your exponential growth will be in the long term.
If you can maintain investing about £900 every single month for 40 years at a humble 4% returns per year and with the help of compound interests, there is almost no chance that you won't end up a millionaire.
And with £1,000,000 invested in the UK stock markets, you'll be collecting about £40,000 every single year. That's over £3,300 per month! Without doing anything whatsoever!
Okay, enough talking. Let me show you how to do exactly that!
Key Takeaways:
What are dividends?
A dividend is commonly expounded as the share of profits and retained earnings that a company pays to its shareholders.
Although there are different classes of stock for some companies, a common shareholder is typically eligible to collect this dividend.
Think of dividends as a reward to investors for putting their faith and trust into the company.
Generally, dividends are paid according to how many shares of the stock a shareholder owns.
So for example, if a shareholder has 50 shares of XYZ company that pays £1 per share, it would mean that the shareholder will be receiving a total of £50.
Types of dividends
Cash dividends are the most common of them all. Where companies distribute this amount directly into the shareholder's brokerage account. However, some companies have other forms of dividends that they pay to investors.
Stock dividends - Instead of paying cash, companies will pay investors with additional shares of the stock.
Special dividends - Special dividends are something like a bonus to investors. It's a pay-out to distribute the profits from several years. Companies do this when they have no immediate needs for the funds and don't have plans to further expand the company yet but still want to take care of their investors. Generally a great sign.
Preferred dividends - These are the dividends paid to shareholders of preferred stocks. Works similarly to the dividends on common stocks, but generally, the dividends from preferred stocks are fixed.
Dividend reinvestment programs (DRIPs) - This is a program where companies will offer their stock at a discounted rate for existing investors in hopes that they will choose to reinvest their dividends back into the company's stock.
How do dividends work?
First, the dividends must be approved by the company's Board of Directors before they are paid to investors. Here are a few key terms to take note of:
Declaration date - This is the day where the Board of Directors announce whether they will pay dividends. If they are, there'll also be the date on which the pay-out will happen and the date of record.
Date of record - Also known as the ex-dividend date. It's when the company checks its record to verify the shareholders of the company. So if you only invest after this date, you won't be eligible for the pay-out.
Payment date - The day on which the company will distribute its dividends.
When will you get paid?
Another thing to note is that dividends are generally paid out on a quarterly basis.
But, some companies, with their own rationale, will choose to opt for a monthly pay-out.
Some others, however, will choose an annual payment.
It really depends on what the company is comfortable with but knowing when it will be distributed often helps you better plan your finances.
What happens post dividend date?
Once you pay for that coffee, you don't just walk up to the barista and want your money back.
On normal occasions of course, and as a normal human being.
Similarly, after companies pay you the dividends you deserve, the money is yours and the companies cannot take that back.
Because of this, there are traders out there who, after getting the details about the dates, decide to buy the stock just to get paid dividends. And after the dividends are paid, they look for the exit.
Ergo, right after the announcement, there is a good chance that the chart will see a ramp-up leading towards the pay-out day.
Then followed by a decline post pay-out day as the traders pile on the supply side.
How do you get dividends?
Although the definition of dividends represents a regular payment made to shareholders of a company, the truth is that not all stocks pay dividends.
When a public company makes a profit, there are only two ways they can use that money.
Reinvest in the business.
Pay it out to shareholders as dividends.
Why do companies pay dividends?
Companies that pay dividends are known as dividend stocks. And the ones that fall into this group are generally huge and established companies.
The idea behind it is that these companies are so huge that there is not much growth left in the markets for them. Investors aren't really going to invest in this company in hopes that the company will grow even bigger. Hence to attract investors, the companies will choose to offer dividends instead.
More than that, dividends are also a sign of financial strength.
Companies can only pay their investors dividends after taking care of all their operating costs. So if there is money left after this and there are dividends, it means that the company is generating a net profit. Vice versa.
Examples (Sectors):
Utilities
REITs (Real Estate Investment Trusts)
Oil & gas
Telecommunications
Why do companies not pay dividends?
A young and growing start-up company, however, will more often than not, plump for not issuing any dividends at all, or very tiny amounts of it. These companies need every last penny they can get to support their R&D or fuel their growth strategy.
These stocks are known as growth stocks.
Nonetheless, because the company is reinvesting its profits into the business and rapidly growing, this growth will eventually reflect on its stock. This is why, on average, growth stocks have a much higher return in terms of the growth of the stock when compared to dividend stocks.
Bottom line:
The key concept is that companies who pay dividends are in such a saturated market that there is arguably little to no room left for growth. Ergo, the company resort to the concept of offering dividends as a strategy to attract investors.
On the other hand, for the companies that are still growing, there is plenty of room for them to expand and ultimately increase their revenue. But to get to this spot, it will require the company to reinvest their profits into the business. This growth is what attracts investors as it will reflect on the prices of its stock.
How to evaluate dividends?
Evaluating dividends can be a process that involves many moving parts. But here are the five most important details that you must know before making that investment.
Dividend per share (DPS)
Pretty self-explanatory. A dividend per share is how much dividends you're getting paid for owning one share of the company.
Keep tabs on the DPS of a company and compare it with the previous dividend amounts. Doing so will reveal to you which company is actually growing consistently.
Dividend yield
The dividend yield makes it easier for investors to accurately gauge the returns and compare them to other assets.
A £12 stock paying £0.04 monthly (£0.48 per year) has the same dividend yield as a $100 stock that pays £1 quarterly. Both of these have a 4% yield.
Dividend payout ratio
Pay attention to the payout ratio as it can indicate the goal behind offering dividends. The payout ratio is how much dividends the company is paying compared to its net income.
To illustrate, if a company pays out 100% of its income, it means that the company does not have any money left to reinvest in its own business, might not have enough cash reserves to pull through an economic downturn and will definitely have a drop in dividends during a recession.
It really depends on what the goals of the company are but in general, payout ratios that are between 35% to 55% are considered as a safe number.
Dividends vs price
It's a common misconception for some investors to think that dividends are completely separated from the price of the stock. In reality, there is no telling what really affected the stock prices and if something has an impact. The same goes for the relationship between dividends and the price of a stock.
But, as for dividends and the stock price, they are actually more interrelated than you might realise. They have an inverse relationship.
What usually happens when the stock price falls (an indication where the company's future may be bleak) is that the dividend yield will increase.
As an investor, having a negative outlook is not what we're looking for. The ideal is to have growth in our principle and growth in the dividends to get that compound interest.
With that, one of the most crucial pieces of information to have is to consider the elements that enable the company to grow. When the company grows, the dividends will increase as well.
A healthy company
You need to be a detective for a bit and go digging through the company's financial statements. Find out all the red flags that are present and evaluate them.
For example, if a company is not funding their dividends through operations and cash flow, there is a good chance that it's depleting assets or taking out loans to pay for it. And that is not exactly a sustainable practice.
Scott Davis, the senior portfolio manager at Columbia Threadneedle Investments emphasised that the single best thing to look for when dividend investing is a healthy company.
A company that has a consistently growing cash flow and earnings.
Dividend growth
Finding a company with a track record of consistent dividend payout and growth potential is like hitting the jackpot. This is one of the areas that dividend investing really shines because bonds and their fixed rates can never provide a consistently increasing income like stocks do.
Having a good track record signifies resilience within the company and are prepared enough to face each business cycle.
Good-to-knows
Even though I think dividends are a great investment to have, I do have to show the other side and play the devil's advocate.
Dividends are not guaranteed
The Board of Directors has full control over whether or not they want to issue dividends.
That means if things go south, despite the multi-year or multi-decade track record, they can and are entirely permitted to not issue any dividends at all.
On top of that, the amount that the companies pay out is not guaranteed as well.
Therefore, betting everything you have on dividend stocks can be a risky play. Although the chances of not getting your expected dividend payout are rather low, there is still a chance of that.
There are dividend ETFs
An easier alternative to doing all the work yourself is to invest in a dividend ETF. There are thousands of ETFs trade globally as I write. Some more sector concentrated while others may have a larger basket of stocks.
These stocks have been carefully selected by the institutions, hence most of them have a specific purpose that targets a specific kind of investor. For example, having only dividend aristocrats in the basket.
Because of this, there is bound to be a few that fits your criteria.
What's more, is that because ETFs are a basket of stocks, your risk is ultimately lower. The downside is that it may take a much longer time for your principle to grow.
Conclusion:
Dividends are great. I love them.
But, unlike bonds, it does not guarantee any returns. Rather, think of it as an alternative to speculating in growth stocks. An alternative that is considered as one of the greatest tools to reap the compound interests.
Government bonds, corporate bonds, growth stocks, dividend stocks, real estate, options and futures all have a place in the market. Be sure to understand each one of them before making your decision to invest in one or the other.
