Author: Jelle Huisman
Many investors are looking for companies that pay dividends periodically. In addition to achieving price gains, the main reason for investors to invest in stocks is the payment of dividends. In this article you’ll read what makes dividend so attractive, what misunderstandings there are about dividend and how to select the best dividend stocks yourself.
What is dividend and what makes dividend so attractive?
Dividend is a profit distribution of a company to its shareholders. Companies can choose to withhold their profits and invest them in the company, or to pay out a part of it to shareholders.
Dividend investing is extremely popular. This is not without reason. Dividend is often paid out by stable companies that make a structural profit. Dividends therefore normally provide stable income. Dividend payments from companies are historically less volatile than stock market prices. For example, it regularly happens that in a period in which stock market prices fall sharply, total dividend payments continue to increase.
Many investors see dividends as a kind of passive income. Calculated over a longer period of time, dividend also provides excellent protection against inflation. If you invest in shares for several years, dividend will determine a large part of your return. Dividend, dividend growth and reinvesting dividend provide stable long-term capital growth.
Misunderstandings about dividend investing
Investing in dividend stocks seems to be the ideal way to make money with stocks. Nevertheless, there are a number of things we should pay attention to when selecting dividend shares. First we look at a few misunderstandings that exist about dividend investing.
Dividend income offers a guarantee of return
Companies that are known for stable returns will do their best to keep the dividend percentage at the same level. Even when results are disappointing, a company may still choose to pay dividends. Keep in mind, however, that as an investor you have no guarantee of dividend. So it can happen that a company suddenly pays out a much lower dividend, or no dividend at all.
A high dividend yield is always a good sign
The dividend yield is often used to compare listed companies. The dividend yield is the ratio between the profit distribution and the share price. For example, if a company pays a dividend of 0.50 euro at a share price of 10 euro, the dividend yield is 5 percent.
A high dividend yield seems interesting of course. However, it is important to see the dividend yield in the right perspective. For example, a company may pay out a dividend yield that is disproportionate to the company’s results. It can also happen that the dividend yield is very high, because the share price of the company has fallen sharply.
Companies that pay dividends are always strong companies
It is not the case that companies that pay dividends are always strong companies. For example, it may happen that a company pays dividends after a business unit has been forcibly sold. It also happens that companies pay dividends because they themselves see few opportunities in the market for innovation or expansion. In this case the money is paid out to shareholders, instead of being invested in the future development of the company. So it is important to also look at the company’s results.
How to select the best dividend stocks?
Dividend-paying stocks are an excellent basis for an investment portfolio. We know already that we need to spend the necessary time and attention on selecting the best companies.
Below are a number of tips for putting together an income-focused stock portfolio.
Look at the business model and the fundamentals
The selection of a strong company is a first requirement. For example, a company can be judged on market position, results and its management in office. However, many investors make the mistake of judging companies on the amount of the dividend first.
Companies that are able to pay out dividends every year are often companies that are stable and grow structurally. The dividend policy can therefore say something about the stability of a company. If a company is able to pay out a dividend every year, over a period of years, this may indicate a company that performs well under varying market conditions. Companies that have only been paying dividends for a few years are more difficult to assess. So first do the necessary research before buying a share.
Assess the payout ratio
The payout ratio indicates the portion of the net profit that is distributed to shareholders. When 20 percent of the net profit is distributed, the payout ratio is 20 percent. Since the calculation of the dividend yield is partly determined by the share price, the payout ratio is often more reliable. The payout ratio also says something about the dividend policy. A lower payout ratio means that a company reserves a larger part of the net profit for further growth or other purposes. A high payout ratio means that a larger part of the net profit is paid out to shareholders. A payout ratio of 35 to 50 percent is considered a healthy percentage by most dividend investors.
Assess creditworthiness
One of the ways listed companies use to raise capital is by issuing loans. If a company’s creditworthiness drops, it will have to take steps to get it back on track.
The creditworthiness of companies is assessed by so-called rating agencies. Some examples of rating agencies are Standard & Poors, Fitch and Moody’s. Rating agencies give companies a risk score, which can vary from AAA (highest credit rating) to D (lowest credit rating). When a downgrade threatens, a company may choose to pay a lower dividend, or no dividend at all. In doing so, the company tries to secure the cash flow available, and thus a good rating. The creditworthiness of listed companies can be found on various websites.
Assess the quality of the available cash flows
To assess whether a company will continue to be able to pay dividends in the future, we can look at the quality of the cash flows available. If the cash flow deteriorates, or the debt burden increases, this can influence the dividend policy.
Assess active share buy-back programs
Many listed companies buy back their own shares if possible. Repurchasing own shares reduces the number of outstanding shares. A company then has to divide the profits made over fewer shares, which can normally lead to a further increase in dividend yield. When a company discontinues or postpones a share buy-back program, this may indicate liquidity problems or increasing debt. This can have a negative impact on the dividend.
Assess whether a company is a dividend payer or a dividend grower
Companies that pay dividends can roughly be divided into dividend payers and dividend growers.
Dividend payers are usually companies with a stable business model and predictable cash flow. Companies that are characterized as dividend payers often have limited growth, but often pay out a relatively high dividend.
Dividend payers are typically companies that grow but pay a low dividend. They are often younger companies in sectors that move with the economy and market conditions.
Ensure sufficient diversification
When investing in dividend shares, you also need to ensure sufficient diversification in your stock portfolio. Certain sectors are known for the high dividend that is paid out. If you own too many shares of companies in one industry, you could run the risk of having too little diversification in your portfolio.
Conclusion
Dividend investing is a great way to achieve capital growth. We have seen that there are a number of points to consider.
At first try to be skeptical about companies with a high dividend. It may be that companies with a high dividend yield are more risky or more sensitive to the economic cycle than other companies. Especially when a high dividend yield is the result of underperformance, and when dividends are paid out at the expense of economic growth, you have to be careful. Always try to ask yourself why a company actually pays dividends.
An investor may want to opt for companies with a slightly lower dividend yield, which are growing fast. Earning dividend income becomes easier if an investor invests for the longer term.
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