The two most obvious ways of making money from a stock are selling it for more than you paid for it and getting dividends. While not all companies pay dividends (often for good reasons, such as investing profits back in the business), dividends can be attractive.
Stock Market Dividends Explained
A dividend is a portion of the earnings of the company paid to every shareholder. As an owner of the company, you're entitled to its profits.
Mature businesses—businesses with reliable earnings—can afford to pay dividends because they produce reliable profits. While not every business which pays dividends is great and not every great business pays dividends, there's a correlation between successful businesses and reliable dividend payments.
One benefit of quarterly dividend payments is that you get paid as long as you hold the stock. Unlike the unrealized gains of stock price appreciation, that's profit in your bank account every three months. (Of course, you probably have to pay taxes on those dividends, but if you're looking for recurring income from your investments, it's a nice feature.)
If you don't need the additional income, dividend reinvesting is a great way to roll your profits back into good companies to increase the amount of stock you own.
If owning dividend-paying stocks is good, then buying good dividend stocks may be worth your time. How do you find them?
Part of the process is identifying good companies. Good businesses make good stocks. Buy a great stock at a good price and you'll make money in the stock market; that's the value investing advice which serves investors such as Benjamin Graham, Charlie Munger, and Warren Buffett well. That's step one.
Step two is to find some way to compare the dividend-producing ability of one potential stock against another. For that, you need a simple ratio.
What is the Dividend Yield Ratio?
The dividend yield is a ratio of the annual amount of dividends paid per share divided by the current price of a stock. If a stock costs $10 per share and pays $0.25 in dividends every quarter, that's $0.25 times 4 quarters divided by $10, or $1 divided by $10 or a 10% dividend yield.
You can flip the dividend yield ratio on its side to get an interesting number. In this example, the market is willing to pay $10 right now to get $1 in dividends over the next year. That's similar to the P/E Ratio, but it focuses on what the stock is likely to pay out. Perhaps the dividend has already been announced or perhaps the company has reliable quarterly dividend payments.
What Does the Dividend-Price Ratio Indicate?
A strong business with a higher dividend ratio may be undervalued. This could represent a good opportunity to buy a stock that returns profit to its investors every quarter. Similarly a business with a very low dividend yield may be overvalued. You have to be careful, though. Do your research. What's the company's history of paying dividends? What's its history of generating free cash?
A struggling company may choose to raise its dividend in order to attract more investors to prop up its share price. This is a risky strategy. If you understand the underlying financial state of a business, you can reduce your risk of buying a messy stock.
What is a Good Dividend Yield?
A dividend yield of 10% is fantastic and unrealistic. (It's an example here to make the math easier.)
The normal S&P 500 index dividend yield is somewhere around 2% (for companies which pay dividends). That's not a huge amount, and you're not going to get rich off that amount, but it is a baseline. Anything between 2-3% is pretty normal, and anything above that is worth examining.
Of course, the dividend yield of a stock you already own depends on the price you paid for the stock. If, as one of the writers on this site did, you paid $3.73 per share of Cypress Semiconductor a few years ago, the $0.44 it pays annually has a personal dividend yield of 11.8%, instead of the current dividend yield of 3%. (Said writer is still long on CY.)
Chasing higher dividends may lead you to riskier stocks. Remember to look at the health of the underlying business. There's little value in getting a 5% yield on paper if the company starts losing money next year. Yet even so, healthy companies which pay dividends can help you achieve your goals from investing in the stock market.
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