Many people invest in dividend-paying stocks to take advantage of the steady payments and the opportunity to reinvest the dividends to purchase additional shares. Since many dividend-paying stocks represent companies that are considered financially stable and mature, the stock prices of these companies might steadily increase over time while shareholders enjoy periodic dividend payments.
In addition, these well-established companies often raise dividends over time. For example, a company may offer a 2.5 percent dividend one year and the next year pay a 3 percent dividend. It’s certainly not guaranteed; however, once a company has the reputation of delivering reliable dividends that increase over time, it is going to work hard not to disappoint its investors.
A company that pays consistent, rising dividends is likely a financially healthy firm that generates consistent cash flow (this cash, after all, is where the dividends come from). These companies are often stable and their stock prices tend to be less volatile than the market in general. As such, they may be lower risk than companies that do not pay dividends and that have more volatile price movements.
Because many dividend-paying stocks are lower risk, the stocks are an appealing investment for both younger people looking for a way to generate income over the long haul and for people approaching retirement - or who are in retirement - who desire a source of retirement income.Contributing further to investor confidence is the relationship between share price and dividend yield. If share prices drop, the yield will rise correspondingly.
Power of compounding
Dividends often provide investors with the opportunity to take advantage of the power of compounding. Compounding happens when we generate earnings and reinvest the earnings, eventually generating earnings from the earnings. Dividend compounding occurs when dividends are reinvested to purchase additional shares of stock, thereby resulting in greater dividends. Given time, money can grow, especially if earnings are reinvested. This is the power of compounding, called by Albert Einstein “the eighth wonder of the world.”
With dividend investing, the more often you receive and reinvest your dividends, the higher your eventual rate of return. To illustrate a more realistic example of compounding, assume you purchase 100 shares of stock XYZ at Rs.50 per share, for a total investment of Rs.5,000. The first year that you own the stock, the company pays one 2.5 percent dividend, earning you Rs.125 in dividend income. If the dividend increases by 5 percent each year (5 percent of the previous dividend; not 5 percent of the stock’s value), your Rs.5,000 investment would be valued at Rs.11,226 after 20 years (assuming there’s no change in the stock price and that you reinvested all of the dividends).
Now, imagine the situation is the same but that the company pays a quarterly dividend (instead of the annual dividend in the previous example). Your Rs.5,000 investment would grow a bit more to Rs.11,650 over the next 20 years, for a total gain of 133.01 percent. Bump up your initial investment to Rs.50,000, however and you will end up with Rs.116,502 after 20 years because of the power of compounding.
To take advantage of the power of compounding you need:
- An initial investment
- Earnings (dividends, interest, etc.)
- Reinvestment of earnings
Doing your homework
Similar to any other investments, it is important to perform due diligence prior to making any dividendrelated decisions. There are several factors to consider when researching and selecting dividend stocks, including the dividend yield, dividend coverage ratio and the company’s history of dividends.
As mentioned previously, the dividend yield shows how much a company pays in dividends each year relative to its share price. It is calculated by dividing the annual dividends per share by the price per share.
It would make sense that the higher the dividend yield, the better the investment but this financial ratio can be deceptive. Remember that this ratio increases as share prices drop. A dividend yield that is unusually higher than other stocks in the same industry may indicate that the stock’s price may drop or that future dividend will be cut or eliminated. This can spell doubletrouble for investors who will lose money both on the falling stock price and the loss of any future dividend income.
Dividend coverage ratio
The ratio between a company’s earnings and its net dividend to shareholders is known as dividend coverage. This ratio helps investors measure if a company’s earnings are sufficient to cover its dividend obligations. Dividend coverage is calculated by dividing earnings per share by the dividend per share: Dividend coverage = (Earnings per share)/(Dividend per share) For example, a company that has earnings per share of Rs.7 and pays a dividend of 2.5 would have dividend coverage of 2.8 (Rs.7 ÷ 2.5 = 2.8).
In general, a coverage ratio of two or three shows adequate coverage and that the company can afford to pay a dividend. If the ratio falls below two, it could indicate that a dividend cut is on the horizon. If the ratio falls below one, the company is likely using last year’s retained earnings to cover this year’s dividend. A ratio that is high, such as greater than five, may indicate that the company is ‘holding out’ on investors and could have paid a larger dividend to shareholders.
Companies that boast consistent dividends, particularly if dividends increase over time, are typically financially stable and wellmanaged. While a good track record does not guarantee future results, a company that has performed well in the past may be less risky than one with a spotty or inconsistent history.
That said, any dividend-paying company must pay its first dividend at some point - companies with excellent fundamentals may wait (longer than investors would like them to) to begin paying dividends.
It is important to remember that investing in any stock - whether the company pays a dividend or not - is not a risk-free investment. In addition to researching on the front end, investors should monitor their investments and consult their investment advisors when necessary.
Many investors seek dividend-paying stocks as a means of generating income and growing wealth. As with any investment, it is important to do your homework and find investments that are suitable to your investing style, time horizon, financial situation and financial objectives. A variety of resources and tools are available in print and online to help you make investment decisions.