Dividends are one of the best ways that companies can return value to shareholders. Share buybacks have become all the rage in the investing world, and dividends have been pushed to the back burner. But this underappreciated method of investing creates wealth over time like no other with the power of compounding.
I thought with this post, I would create a guide about dividends to give you a one-stop-shop to find out everything you might need or want to know about dividends.
Not all companies pay dividends, and they have their reasons for doing so, but the companies that do are regarded as shareholder-friendly. Even though Warren Buffett doesn’t pay a dividend with Berkshire Hathaway, he invests in companies that do pay a dividend.
Buffett understands the power of compounding and how dividends can grow the wealth of both shareholders and companies. Buffett has shown over the years that he can compound Berkshire’s money at rates that are difficult to replicate elsewhere and has arguably earned the right not to pay a dividend. But that is an argument for a later day.
Items we will learn today:
- What Are Dividends?
- Dividend Metrics That Matter
- The Impact of Compounding and Dripping
- The Best Dividend Paying Stocks
Ok, let’s dive in.
What Are Dividends?
Put simply, dividends are payments made from a company to the shareholders or individuals that have purchased shares of the company. Any owner of the stock of the company, individual or fund, is eligible to receive dividends from the company.
Not all companies pay dividends; some of that will depend on where they are in their life cycle. Typically young companies will not pay a dividend; rather, they will reinvest any cash flow back into the business to grow the company.
Examples of this might be Amazon, Google, Facebook, and Netflix. These companies are still in the growth at all costs stage and are using any extra money to grow the company. Our discussion today will not delve into the right or wrong of this idea, rather how we can benefit from the companies that do pay a dividend.
Dividends are typically paid quarterly, or every three months. But they are also paid semi-annually, like Disney. Or they can be paid every month, or once a year. A lot of it will depend on each company and how their business is set up.
How do Dividends Work?
Dividends are cash that the company pays you for owning shares of the company. Typically, the money is transferred directly to your brokerage account whenever the dividend is paid, but it can also be reinvested back into the company by a process known as DRIP, more on this in a moment.
Dividends must be declared by the board of directors each time the company pays a dividend. When the company announces a dividend, they will announce how much will be paid, when the dividend will be paid, and the ex-dividend date occurs.
What is the ex-dividend date?
Well, that indicates that the investor that wants to receive that dividend payment must be a shareholder of record on or before that date. Keeping in mind that ownership doesn’t always happen immediately when you purchase a company through your brokerage. That means that the ex-dividend date is important to note if you are considering becoming a shareholder.
Dividends are paid out of the cash flow of a company, the actual amount distributed is available for all to see on the cash flow statement of any public company, you can find it on any 10Q or 10K report. Every year the board of directors will indicate how much a company is budgeted to pay out as dividends. Then it is up to the CEO and other managers to inform the board that they would like to distribute a dividend, and then it is declared.
What are the impacts of dividends on an investment? Certainly, this will vary, but let’s look at the impact it has had on returns of the S&P 500 as a reference.
Over the 90 years between 1871 and 1960, the dividend yield for the S&P 500 never fell below 3%, with the period from 1960 to 1990 there were only five years that the yield fell below 3%. Since the 1990s, there has been a trend away from dividends towards share repurchases as a form of returning value to shareholders.
Some of this change is reflected in the low-interest rates that have permeated the markets since 1987 and Alan Greenspan and the rise of internet-based companies, which are typically growth players and not interested in dividends.
The S&P 500 has returned between 10 to 11 percent returns over the time of its inception in 1878 to 2019, with around 2.5 and 3 percent of those returns, including dividends.
Let’s put some numbers to that to give you some perspective.
If you invested $10,000 in the market for 90 years with a return of 10 percent, you would receive $53 million-plus; likewise, if you invested the same amount with a return of 7 percent, you would receive $4.4 million for the same time.
That is the impact that dividends can have on our portfolio, and it is pretty impactful.
Ok, let’s look next at how we measure dividends.
Dividend Metrics that Matter
Four main metrics are in use to measure dividends. The use of the metrics allows us to measure the company’s performance against its peers. And it gives us a better sense of the dividend performance of the company.
Dividends Per Share
The definition for dividend per share according to Investopedia:
“Dividend per share (DPS) is the sum of declared dividends issued by a company for every ordinary share outstanding. The figure is calculated by dividing the total dividends paid out by a business, including interim dividends, over a period of time by the number of outstanding ordinary shares issued.”
The dividend per share metric is important to shareholders because this metric tells us how much cash we receive for each share of the company we own. It is also the most straightforward way to indicate how much money a shareholder will receive overtime, regardless of the price fluctuations of the stock.
Growing the dividend is also an important consideration over time because it tells us how likely the continuation of the growth will continue.
Calculating dividends per share is straightforward and simple; we take numbers from the income statement in shares outstanding and use them to divide by the dividends paid out that we can gather from the cash flow statement.
Dividends Per Share = Dividends Paid / Shares Outstanding
Let’s use a dividend aristocrat to calculate the dividends per share formula. How about Coca-Cola (KO), one of the oldest in the ranks of dividend aristocrats?
I will look up both financial statements from the latest annual report or 10-k and highlight the numbers we need. All numbers unless otherwise stated, will be in the millions, for reference.
Pulling the numbers from the above financials:
- Dividends paid out – $6,845
- Shares Outstanding – 4,314
Now, we can plug the above numbers into our formula to find the dividends per share.
Dividends per Share = $6845 / 4314
Dividends per Share = $1.58
Coke is one of a member of a group called the Dividend Aristocrats, more on them in a moment. Coke has paid a dividend since 1920 and has increased its dividend each year since 1996.
You can quite easily pull this number from your favorite financial website, but since it is so easy and it is always best to go to the source documents, I encourage you to take the few extra minutes to do this yourself.
The above number is the amount that Coke will pay you each year for each share of the company you own, but since Coke pays the dividend quarterly, you would divide it by four to find out how much you would receive each quarter.
$1.58 / 4 = $0.39 per quarter
We are moving on to the next metric in our dividend arsenal.
The dividend yield, which you find expressed as a ratio, is the dividend per share divided by the current market price. The Ratio tells us how much the company pays out each year, and since it is tied to the market price of a company will fluctuate daily.
The benefit of using a dividend yield is the ability to compare that yield to other companies. It is using a metric like per share is not the best as a comparison because every company that pays a dividend is in a different position financially, and some companies that are more mature can pay out more of its cash flow in dividends than younger companies.
Companies that are in the utility and consumer staple sectors typically have larger dividend yields, as do REITs, which are real estate investment trust and are under different covenants regarding their financial distributions. Also, in the higher paying realm are financial companies such as banks and insurance companies.
Companies such as REITs, MLP (master limited partnerships), and BDCs (business development companies) all payout higher yields, but they also are required to tax the dividends at a higher rate.
Let’s calculate a yield using Coke as our example; we can take our calculated dividend per share of $1.58 and compare that to the current market price of $44.28.
Dividend Yield = Dividend per Share / Current Market Price
Dividend Yield = $1.58 / $44.28
Dividend Yield = 3.56%
You could also use the current trailing twelve-month dividend per share, which is $1.61 and compare that to the current market price, which gives us a yield of 3.64%.
As you probably noticed, the yield and stock price are inversely related. As the price goes down, the yield will rise, and vice-versa.
There are two ways to raise a dividend yield for a company, and they are:
- Raise the dividend of the company
- A falling stock price with the dividend remaining the same will raise the yield.
One thing to always keep in mind regarding dividend yield, a rising dividend yield does not always indicate a great investment because, in many cases, it is related to a sharply falling price.
Anytime you see a high dividend yield, typically above 4%, should indicate additional research to determine the cause of the higher yield, especially in businesses that usually don’t pay out such high yields.
It is a good idea in the middle of a quarter to take the last known dividend and multiply that by four and then use that yearly dividend to divide it by the current market price to get the most current yield for any analysis you are doing.
Remember that the dividend yield tells us how much return we will receive for investing in the company in regards to the dividend of the company, regardless of how the share price fluctuates.
Ok, let’s move on to the next dividend metric.
One of the quickest ways to determine the safety of dividend payout is to look at the payout ratio.
The dividend payout ratio is the amount of dividends paid out in relation to the earnings or net income of a company. The Ratio is expressed as a percentage of earnings paid out in dividends. The amount of leftover is often used to pay down debt or reinvest into the company.
The dividend payout ratio tells us how much money the company is paying out to investors in relation to how much it keeps for operations of the business or paying down debt or adding to retained earnings (cash reserves).
Several things we must consider when looking at the dividend payout ratio. First, a younger company that is entirely focused on growth will either pay no dividend or a limited dividend. Rather those companies will use all of its funds to grow the company and may be excused for not paying a dividend at that time.
Where a more mature company will typically pay out a larger portion of its earnings as dividends to reward shareholders for owning the company or to compensate for the lack of growth in the company.
The formula for calculating the dividend payout ratio:
Dividend Payout Ratio = Dividends Per Share / Earnings Per Share
Going back to the financial documents, we will pull numbers from both the income statement and cash flow statement from the latest 10q for Coke.
- Earnings per share – 0.64
- Dividends paid out – $1,760
- Shares outstanding – 4325
Next, we will calculate our dividends per share;
Dividends Per Share = 1760 / 4325
Dividends Per Share = $0.41
Now we can calculate our payout ratio.
Dividend Payout Ratio = 0.41 / 0.64
Dividend Payout Ratio = 63.5%
Now, that simple process tells us that Coke pays out 63.5% of its earnings as dividends each quarter, which will fluctuate as the earnings per share fluctuates, or the dividends per share fluctuates.
One of the easiest ways to determine the safety of the dividend continuing is by calculating the dividend payout ratio. Typically the lower the number, the safer the number, but again we have to take into account both the industry the company resides and wherein the lifecycle the company occupies.
If you see a payout ratio above 100%, that is a sign of concern because that is unsustainable as it is paying out more than the company is earning. Always investigate if you discover a payout ratio higher than is normal or exceedingly high. There might be a situation where a company is paying out a special dividend from extra income, and that can drive the payout ratio higher, as would the dividend yield.
Growth Rate of Dividends
Another metric that is useful when determining the strength of a continuing dividend is the dividend growth rate. The growth rate is determined by annualizing the growth rate of the dividend over some time, such as five years.
Many mature companies such as AT&T, Johnson & Johnson, Coke, and many others seek to grow their dividends over time. Any company that exhibits strong dividend growth indicates that dividend growth is likely to continue, but it also signals the long-term profitability of the company.
The growth rate is also used in the dividend discount model as a means to calculate the intrinsic value of the company.
We can calculate the dividend growth of a company by taking an average of the growth over time. In our case, we will look at the growth of AT&T’s dividend over five years and determine the growth rate.
The dividend payouts of AT&T over the last five years, including the TTM:
- 2016 – $1.93
- 2017 – $ 1.97
- 2018 – $2.01
- 2019 – $2.05
- TTM – $2.06
To calculate the growth, we use the following formula:
Dividend Growth = Dividend(YearX) / Dividend(Year(x-1) – 1
In the above example from AT&T, the yearly growth rates are:
- 2016 Growth Rate = NA
- 2017 Growth Rate = $1.97 / $1.93 – 1 = 2.07%
- 2018 Growth Rate = $2.01 / $1.97 – 1 = 2.03%
- 2019 Growth Rate = $2.05 / $2.01 – 1 = 1.99%
- TTM Growth Rate = $2.06 / $2.05 – 1 = 1%
Now we add all the growth rates up and take an average of them to find our growth rate.
AT&T Growth Rate = (2.07 + 2.03 + 1.99 + 1) / 4
AT&T Growth Rate = 1.77%
Compare that to the five-year growth of the closest competitor, Verizon, which has a 2.4% growth rate of its dividend.
Calculating the growth rate of the dividends is important as a means of comparison to others in the same sector as you can determine the financial strength of both the company and its competitors. Plus, it helps determine the likelihood of a continuation of the dividend and what can kind of growth you can expect from the company in the future.
Dividends Plus Buybacks
With the increase in share repurchases as a means of returning value to investors, it is a good idea to consider those returns in conjunction with dividends.
Many of the same metrics we use, such as dividends per share, can be calculated using the amount of money that a company uses to repurchases shares.
Let’s consider a company like McDonald’s that has a strong history of dividend payouts and a rising dividend, but also has a strong history of share repurchases.
If we were to look at the dividends + repurchases per share, we could see how much the company returns to its shareholders via both ideas.
I am pulling the above line items from the cash flow statement for McDonald’s from the latest 10k, December 2019.
- Shares Outstanding – 758.1
- Dividends Paid – $3,581.9
- Share Repurchases – $4,976.2
We can calculate our dividends per share, plus the dividends buybacks per share.
Dividends And Repurchases Per Share = (3581.9 + 4976.2) / 758.1
Dividends and Repurchases Per Share = $11.29
That tells us how much the company returned to shareholders for each share they own, but another aspect of this is to look at the yield of the above metric to determine how sustainable it remains.
Earnings per share for McDonald’s for the past year was $7.95 a share, and the current market price is $179.25; when we calculate our yield, we find that it is 6.29%, and the payout ratio is 141%!
The yield is fantastic, but the payout ratio is unsustainable. How could McDonald’s payout that much? Well, they did it in two ways, one was to reduce the retained earnings of the company, which is a cash reserve, they also issued debt to sustain the share repurchases, which is one of the many reasons the company has been in hot water recently with investors.
I used McDonald’s to illustrate the effect that share repurchases can have on our investments and also an illustration to check the yield and payout ratio quickly as a check.
Ok, now that we have an understanding of some of the metrics concerning dividends, let’s look at the effect dividends can have on our investment returns.
The Effect of Compounding and Dripping Your Dividends
A visualization to explain how dividend investing can grow your wealth.
Imagine a snowball on the top of a hill, as it begins to roll down a hill it picks up speed, but it also starts to grow as more and more snow is added to the snowball. By the time the snowball reaches the bottom of the hill, it is at top speed, but it has also grown in size, which helps increase the speed and on and on it goes.
The above example is an illustration of how compounding works and how investing with dividends can help grow your wealth.
Think about the famous line about compounding and its power from Albert Einstein:
“The most powerful force in the world is compounding interest.”
Another illustration of the power of compounding, think about investing $1 a day with 1% compounded daily. In five years, your $1 would be worth $77 million, and by the seventh year, you would be the richest man in the world.
Pretty powerful stuff.
Consider this; compounding is not a get rich quick scheme, rather it is a continuous grinding that builds your wealth slowly like that snowball rolling down the hill.
Now, what does all this have to do with dividends?
Buying companies that pay a growing dividend over time will grow your wealth because of the effect of compounding. Using the metrics above, we can find companies that pay strong, growing dividends that are likely to continue for years into the future.
Using those metrics helps you find companies that will help grow your wealth; otherwise, you are reliant on the price appreciation of the company only.
In addition to the power of compounding, we need to examine the power of DRIPs.
As we mentioned earlier, DRIPs are known as Dividend Reinvestment Programs, and you have a choice of either doing this directly with a company such as Coke, or you can elect to have your brokerage handle that for you.
In essence, a DRIP is taking the cash that you are paid for your investment in the company from a dividend and then using that cash to buy a fractional share of the company. For example, when Coke issues its quarterly dividend, your brokerage will take that cash and buy a fraction of the share.
The quarterly dividend for Coke is currently $0.40, and let’s say you own one share of Coke, when the company issues its dividend, instead of cash going directly into your brokerage account. The brokerage instead will purchase a portion of the share of Coke, which is currently priced at $44.36, which means for that dividend per share, we would get a portion of Coke that equals $0.01.
Now I know you are saying Dave, what’s the big deal with one cent? Well, that one cent now adds to the total of your investment in Coke, which would mean that the company is now worth $44.37 to you, and you would get a greater portion of dividends on the next payment. As those dividends grow, so does your total investment, and it continually compounds as both the dividend and your total investment grow, so it is a double compounding effect.
For more details on the power of DRIP Investing, please look below:
And for more on the power of compounding, below:
And now, let’s dive and discover some of the options for finding great dividend-paying companies.
Best Dividend Paying Stocks
There are several options to consider when thinking about adding companies that pay a dividend to your portfolio. Among them are the types of companies you are considering, such as growth, what kinds of industry you are considering, and what your investment goals are.
When investing in dividend companies, all the same rules apply when analyzing any company. We want to find strong companies with a fair price, and any other requirements you consider part of your investment checklist.
The first place is to consider companies that have been paying a growing dividend over a sustained amount of time. That will help you with two aspects, profitable companies that will likely continue paying the dividend, and companies that are continuing to grow their profits to allow them to continue paying dividends.
Luckily there are a few lists to consider when looking for companies with those kinds of track records.
The first is Dividend Kings, which refers to companies that have paid a growing annual dividend for over 50 years! The companies are all listed on the S&P 500, and currently, 29 companies fit this description.
Among them are Coca-Cola (KO), Hormel (HRL), Johnson & Johnson (JNJ), and many more. The company paying the longest growing dividend with 65 years is American States Water (AWR).
The second list, which is probably more familiar to those who have been investing for a little longer, is the Dividend Aristocrats, which comprises of the Dividend Kings, along with new companies that are in the S&P 500 and have paid a growing annual dividend for 25 years or more.
The Dividend Aristocrats include up to 66 companies, with the newest additions being Realty Income (O), Amcor (AMCR), Ross Stores (ROST), among many others.
Using the Kings and Aristocrats as starting points to find a strong, dividend-paying company is a great place to start to find great investments that will grow your wealth.
Additional lists you can cull are for Dividend Contenders, you have paid a growing dividend for ten to years, or the Dividend Challengers who have paid a growing dividend for five to nine years.
You can find lists of all the above companies to begin your research below:
As with any aspect of investing, doing your due diligence when you discover a company that piques your interest is critical. Never buy a company just because it pays a dividend for 65 years; you need to find the right price. If you like a particular company, but it is too expensive, then put it on your wish list and be patient.
Other options include looking at REITs, or MLPs that pay outstanding dividends. One thing to note with both of these options is that both come with different accouting rules and special situations regarding taxes. In a sense they have their own seperate language that you will want to learn to invest in those types of companies.
The other option is financials such as banks, investment banks, and insurance companies. All of these businesses pay fantastic dividends as well, but they come with their own challenges as well. Again, they have different acccoutning and tax situations to be aware of and consider.
In times of uncertainty, such as today with the Covid-19 pandemic, you might have that opportunity to purchase that company, but remember that the price you pay is extremely important and will have a lasting impact on your returns.
Buying a company that is paying a growing dividend is the holy grail for most investors, myself included. Not all dividend-paying companies are great investments, some are languishing, and solely exists to pay the divided, and that is the only “growth” you will get from the company.
That doesn’t mean it is a bad investment; it depends on several factors such as where it sits in your portfolio and what is its intended purpose, such as AT&T can function as a bond, not growing a lot but paying you a growing dividend.
Any company that starts paying a dividend is more than unlikely to stop that dividend because everyone knows that Wall Street HATES it when a company stops or cuts its dividend. Once that happens, you can automatically price in a huge drop in price, one that will likely take years, if not decades, to recover.
That is why when word of a dividend cut is offered; it is up to whether you continue your relationship with that company; there might be extenuating circumstances like a pandemic, which causes the cut, not necessarily a failure in the business.
Dividend investing is one of the best ways to grow your wealth over time, with the power of compounding and utilizing DRIPs. Dividend companies are typically more stable, secure companies that have growing profitability, which makes them attractive possibilities. Consider adding dividend-paying stocks to the portfolio; your future self will thank you.
That is going to wrap up our discussion for today, as always, thank you for taking the time to read this post.
I hope you find something of value for your investing journey.
Until next time.
Take care and be safe out there,