But before diving into investing with dividends, it is important to understand what a dividend is. There are many types of dividends, but the most common are per-share payments made out to the shareholders of a publicly traded company on a regular, usually quarterly, basis, according to Investopedia. Essentially, dividends are payments made by companies to individuals who hold shares of their stock, as a reward for their investment. The amount that a company chooses to pay out as dividends are determined by its board of directors, according to Investopedia.
Not all companies choose to pay dividends, however. Since dividends come from a company’s total profit, some companies choose to reinvest all or most of their earnings back into growing their business. Young companies trying to achieve rapid growth tend to be among the companies that are unlikely to pay dividends, according to U.S. News. On the other hand, U.S. News reports that mature companies are among those that are most likely to pay a dividend because they usually have fewer reinvestment costs and are more stable.
There are a few important dates for investors to keep track of when it comes to dividend investing. First is the declaration date or when a company initially announces that it will be paying a dividend. Next is the ex-dividend date, which according to Business Insider, is the last day that an investor can buy stock in a company and still be entitled to receiving its closest upcoming dividend. Finally, the payment date is the date on which the investor receives the dividend.
Investors need to be able to evaluate companies and their dividends by a set of important metrics to determine if the company is worth adding to its portfolio.
One metric is known as a dividend yield, and intuitively, this is just the expected dividend as a percentage of the investor’s initial investment, according to the Motley Fool. For example, if an investor buys $100 of a company’s stock, and the company has a dividend yield of 6%, then the investor can expect his or her dividend payments to total $6 over the course of the year. While this metric is very popular, it is one of the least useful metrics, according to the Motley Fool.
The second key metric that investors should know is the dividend growth rate, which according to the Corporate Finance Institute, is the percentage by which a company’s dividends grow over a set amount of time. A strong indicator for the investor to look out for is how consistent a company’s dividends have been historically and whether or not the dividends have increased over time.
A third key metric for investors to consider, and by no means is this list exhaustive, is a company’s payout ratio. The payout ratio is defined as the ratio between a company’s net income and the value of dividends it pays out, according to Seeking Alpha. If this ratio is low, a company might be less willing to pay dividends and more focused on reinvesting its earnings into growth; conversely, a high payout ratio might suggest a company is willing to share more of its profits but might not be as interested in growth, according to Seeking Alpha.
So, how should investors use dividend investing to their advantage after understanding what dividends are and the different metrics used to evaluate them?
A common strategy is to take advantage of the power of compounding through a strategy known as DRIP, or a dividend reinvestment plan. With a dividend reinvestment plan, the funds an investor receives via dividends are automatically reinvested into buying more shares of the company, according to Bankrate. Having more shares equates to receiving more dividend income, in turn allowing the investor to buy more shares, eventually turning into a powerful cycle that yields the investor great returns.