Stocks that pay dividends can be great to own. Before you chase the highest annual payout, learn more about how dividends may cost you!
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A successful company—one which earns real money every year has three options for that cash:
- Reinvest those earnings into the company to make new products, find more customers, build new stores or factories, or make the business more efficient
- Buy back its stock so that each remaining share owns more of the company (and more of next year's profits
- Return money to shareholders in the form of dividends
How Do Dividends Work?
Suppose you loan your best friend $1000 for a year at 5% interest. You expect to get back your $1000 plus that 5%—another $50.
Now suppose you invest in your best friend's business. For every thousand dollars of money invested, the business can make $50. At the end of a year, you still have your $1000 invested in the business, and you have the $50 the business made thanks to your investment. You own a part of the business and you own a part of the profit from the business.
A reliable company like Coca-Cola pays out handsomely every quarter. Even if the share price barely moves every year, investors still make money from these dividend payments. Better yet, they don't have to sell their shares to get that money. The check comes every quarter.
This money gets paid to all shareholders, regardless of the number of shares they own. A retired grandmother in Canada who owns one share of Coca-Cola gets her dividend the same way a wealthy hedge fund manager who has a fifty million dollar portfolio and lives on the beach in Costa Rica does. That's why dividend investing is attractive: it's reliable.
Not all companies pay dividends. Some companies make no profit, so they can't pay out anything (without taking out a loan). Other companies pour all of their money back into the company to grow faster. That's a reasonable choice. What works for one business doesn't work for others.
Stocks that pay dividends pay, on average, about 2% of the value of the stock every year. In other words, if the stock costs about $100, you'll get about $2 every year. That's a 2% return on your investment, before taxes and fees. (Once you take into account federal and state income taxes and inflation, a 2% annual return doesn't sound like much, does it?)
This number is also known as the dividend yield. A company with a share price of $10 and a $1 annual dividend has a dividend yield of 10%. A company with a share price of $100 which pays out $1 per share every year has a dividend yield of 1%.
To determine whether any given stock pays a dividend, use a stock research site such as like Google Finance or Yahoo! Finance. You should see a dollar amount for latest dividend announced, annual amount paid, and current yield. Check these dates; a stock may pay out one quarter and not the next.
Should You Invest in the Highest Dividend Paying Stocks?
High dividend paying stocks may have rates of 5%, 10%, or more. Why so high?
It could be that the share prices have plummeted, usually because investors aren't certain that the business will continue to make that kind of money every year. Alternately, it could be that the company has raised its dividend in hopes of attracting more investors.
The worst case scenario is a penny stock with a huge dividend yield—low price, comparatively high dividend. Remember that the price you pay for a stock and the growth of the business over time govern how much money you make on that stock. Also keep in mind that you will rarely see penny stocks pay dividends! (There's no shortcut to invest little money with high returns. Sorry.)
A high dividend paying stock is paying more than the average dividend rate ompanies that pay high dividends may do so because they're good companies... or because they want to attract investors to drive up the share price. It may be a sign that the share price has gone down, dramatically down, recently. (Sometimes this means the stock is on sale! Great! Other times it means that the company is in trouble.) You can't know this just by looking at the share price and the high dividend amount; you have to understand the company's business and its current financials.
Keep in mind that a company must choose to pay a dividend. Just because it paid one last quarter doesn't necessarily mean that it will pay one this quarter. As well, the amount paid may very. While a reliable dividend stock like Coca-Cola will regularly raise the amount of its dividend payments, not all companies do. A fluctuating business which paid $1 per share last year may pay only $0.02 per share this year.
Are high dividend stocks a good investment? Not necessarily! Pay attention to how they're paid. Do they pay them every year? Every quarter? Does the company raise its payment amount on a regular schedule? The best dividend paying stocks do this. Coca-Cola is a great example; Coca-Cola stock is a good investment, though it's not always available at a great price! If you bought Coca-Cola at a great price a couple of decades ago, you could make more from dividends every year per share than you ever paid for the stock. (That's the misleading part of dividend yield of stocks; it's always calculated relative to the current price, not what you paid.)
Value Investing and Dividends
Investing in stocks that pay dividends can be a good strategy, especially if you want regular cash coming in reliably. Remember that word, reliable.
Reliability is more important than a high payout. Dividends aren't guaranteed. A company that paid a huge amount of money last year but may not pay it again this year isn't necessarily worth owning. Value investors pursue great companies because great companies make money, whether they reinvest it or pay it out.
Can the company even afford to pay out this year? How about next year? A company that pays a huge dividend—especially one disproportionate to its earnings and free cash flow is a warning sign. How does the company plan to continue its payment strategy? Is this a temporary trick of accounting to draw in uncautious investors to inflate the stock price to artificial levels? Be wary. Rely on reliability.
Dividends are great, and many great companies have good dividend stocks to buy. Yet value investing looks for underpriced stocks. Sometimes they pay dividends. Sometimes they don't.
If you find a great company that gives you a check every quarter—and if the price is right relative to the value—then you've found a true gem. They may be rare, but they're out there for you to find, if you do the numbers.