If you’re here, you’re probably facing one of the first challenges of new investors: how to understand dividends.
Dividends seem complicated because dividend incomes depend on several factors –like the company– and are not exactly guaranteed and can fluctuate.
Sounds confusing? Don’t worry!
This post is going to dive into the basics of dividends and how they work. This way, you can evaluate your position and decide if dividend stocks are a good investment option for your portfolio.
Let’s start from the beginning!
Understanding dividends: How Do You Make Money On Dividends?
In the plainest of descriptions, dividends are a fraction of the profit that a specific company decides to split with its shareholders. The return of these dividends will depend on how many stocks you own.
For example, if a company offers a $2 per share dividend and you own 300 stocks, you would receive a $600 dividend payout. A majority of companies that offer dividends tend to do their payouts on a quarterly basis.
That means if you invest in a dividend stock, every 3 months, you are likely to get a dividend payment in your investment account.
Below is an example of one company in which I own shares – Pfizer. I only own 3 shares so my dividend payout is much smaller than someone who might own more shares.
To understand what the dividend payout will be for a particular company, look at the dividend payment ratio.
Why Is The Dividend Payment Ratio Important?
Calculating the dividend payment ratio (aka dividend yield) of the company will help you know the percentage of earnings they’re actually sharing with you (the shareholder).
Which types of companies usually pay dividends?
Companies that tend to offer dividends are those mature and stable firms. These are typically “Blue Chip Companies” that are comfortable covering their operating expenses and tend to have big and stable profits.
On the other hand, start-ups or other ‘unstable’ companies might not offer dividends right away. This is usually because they lack the profits to share and tend to reinvest available earnings back into in their company.
That’s the basics, but not a fast and steady rule. There could be a start up company that decides to give shareholders dividends. It all just depends.
Why do companies pay out dividends?
Ok, this is where how to understand dividends gets tricky.
The main reason an established company would pay dividends could be to indicate financial success. They want their shareholders to stay happy and, therefore, they share their earnings with them.
So, you should always go for a mature company with a high dividend yield, right?
Well, not exactly.
You need to pay close attention to the value of their stocks:
- How they’ve managed the last few years with their finances.
- The mentioned dividend payout ratio.
- The history of the brand and company.
Dividends respond to the economic situation of the company – as they represent a percentage of their net income and whether or not they have flexibility outside that sum.
In this sense, the logical conclusion would be that a company will offer dividends when its finances prosper.
However, that’s not necessarily how dividends work in real practice!
A start up company could choose to offer dividends as a way to entice new investors into buying their stock. Furthermore, established companies, such as General Motors, have also been known to stop or cut back on dividend payments when things get rocky.
That is what I mean when I say understanding dividends payments can be tricky. If a company is facing financial hardships, they do not have to pay out dividends. They can cut back their payout (i.e. go from 3% to 1%) or just end payouts completely.
Consider all those factors when you decide which companies to add to your investment portfolio. Investing is never a one-statistic decision; you must cross examine the underlying data!
So, when are dividends a “Good Investment”?
The final step of how to understand dividends is determining if they’re a good investment for you.
At this point, we already know how dividends work, what companies would pay those dividends, and why.
So, now all that remains is evaluating those fields to find the company that could actually be a good investment.
However, let’s be honest…
Limiting yourself to only dividend paying stocks might be the equivalent of “putting all your eggs in one basket”. So, consider the risks depending on the company and your individual goals! It is usually recommended to have a mixed portfolio that reflects your retirement timeline and risk personality.
I hope this guide helped you on how to understand dividends and provided a better perspective on your journey as an investor!
Let me know below if you invest in any dividend paying stocks. For now, Pfizer is the only individual stock that I own that has a dividend payout. I tend to stick primarily to low cost index funds on my FIRE journey to early retirement.