Entering the world of investing can seem like a daunting endeavor. With so many different stocks, bonds, ETFs, and mutual funds to choose from, how can one ever figure out where to start? For new investors, I believe the answer to this question is large, proven companies that pay dividends.
What Are Dividends?
Dividends are a portion of a company’s earnings, paid out to investors on a quarterly or annual basis. This payment can be in the form of cash, additional shares of common stock, or, in some cases, property. Furthermore, most companies allow investors to choose whether to receive a cash dividend, which is subject to the capital gains tax, or to automatically reinvest said money into additional company shares. However, not all publicly traded companies issue dividends.
Dividends payments are also subject to change. A company may increase or decrease its dividend payments, eliminate future dividend payments, or even offer a one-time special dividend. A dividend's value is dependent on a company’s financial performance and future outlook. If a company has successful quarterly growth, accompanied by positive analyst outlooks, it may increase its dividend. Whereas if a company actively seeks to buy out a competitor, or increases capital investments, it may lower its dividend to compensate for higher expenses. A special dividend may also be issued after a company reports an exceptionally successful quarter, or year. A special dividend is paid out in addition to a company’s regular dividend payment. Furthermore, as recently displayed by Apple (AAPL), companies with low debt and large cash reserves will also issue dividends if their stock price is stagnant. This action returns value to shareholders and keeps them satisfied (in the short-term).
What Is Dividend Yield?
The dividend yield of a stock can be calculated via the following formula:
Dividend yield represents a percentage measurement of a company's dividend/share price ratio. For example, if Exxon Mobil Corporation (XOM) issues an annual dividend of $2.76 per share, and its current stock price is $102.01, then its dividend yield ($2.76 / $102.01) is 2.70%. According to Investopedia, the historical average dividend yield for dividend-paying S&P 500 stocks has been between 2 and 5%. Dividend yield also serves as an indicator of a company's future growth prospects. A low dividend yield often accompanies financially healthy companies with high growth expectations, while a high dividend yield frequently reflects financially unstable companies with low growth expectations. Dividend yields also relate to a company's market capitalization. In most cases, a low dividend yield corresponds to large cap companies, while a high dividend yield corresponds to small and mid cap companies (to help alleviate investor fears and compensate for risk).
Investing In Dividend Stocks
The benefits of investing in dividend stocks are numerous and more importantly, provide investors consistent cash flows. Studies show that about 40 percent of the stock market's total returns since 1930 have come from dividends. Simply, 40 percent of the monies investors have made in the stock market over the past 80-plus years are attributed to investing in dividend stocks. For new investors, the learning curve of investing is exceptionally high and the compensation from investing in dividend stocks provides small but consistent gains, regardless of one’s actual ROI.
When combined with a long-term investing strategy, dividend gains compound and add value to a portfolio. However, this does not mean that investors should only invest in dividend stocks. I believe that investing in familiar, large cap dividend stocks, such as the Coca-Cola Company (KO) or Johnson & Johnson (JNJ), is the best way to generate consistent returns from dividends, while simultaneously mitigating risk within one’s portfolio. These large cap companies are battle-tested entities, which means investors can routinely count on receiving quarterly or annual dividend payments. Moreover, these companies are defined by balanced finances, positive future outlooks, and consistent growth; they would be sound investments even if they did not offer dividends. Ultimately, dividend stocks offer some certainty for investors which, in an economic world plagued by uncertainty, is a comforting feeling.