Chances are that new investors might be oblivious about the concept of dividend as it is related to an investment particularly for a mutual fund or an individual stock. Generally, a dividend is a payout of a portion of company’s net income to eligible shareholders, typically issued by a publicly traded company. Dividends are received from a company’s profit and are a sign of the company’s financial health.
The real question that arises is- do dividend paying stocks make a good investment or not?
People follow a strategy, known as ‘Dividend Investing’, which offers a way to generate a flow of income through dividend paying stocks. Dividend investing is a technique that offers investors with two sources of possible income- capital appreciation over time and expected income from regular dividend payments.
Dividend investing can be an excellent way of earning profit from stocks if you are looking to generate income from dividends or building long-term wealth from the future. Dividend investors generally look for dividend safety, which is measured by the dividend coverage ratio. This ratio is used by to measure the risk of not being paid dividends.
So, if a company has a high percentage of net income to its total annual amount of dividend payments, there is a lesser chance that the business will not be able to meet its dividend commitments.
The formula for dividend coverage ratio is:
Dividend Coverage ratio= Annual net income/ Annual total of all dividends paid to common shareholders
Key Metrics One Should Be Aware of for Dividend Investing
Before buying any dividend stocks, one should conduct a thorough evaluation of them. There are following key metrics one should know before investing in dividend stocks.
- Dividend Yield: The annualised dividend yield is calculated by dividing the annualised dividend along with the present stock price. If the stock price of the company is $10 per share and the company pays $2 dividend, the annual dividend yield would be 20%.
- Payout Ratio: Payout ratio refers to the dividend as a percentage of income. If a company pays $1 per share dividend and earns $2 per share in, the payout ratio would be 50%.
- Annual Total Return: The overall performance of a stock, including appreciation gain from stock and total annual dividend paid.
Rules to Follow for Smart Dividend Investing
- One Should Have a Deep Knowledge of The Stock
A stock can have a high dividend yield simply because of the correction in the stock price. One should not just look at the dividend yield but also the stock performance of the company in the previous period. The dividend yield is inversely related to the movement of the stock price. If the stock price rises, dividend remaining stable, dividend yield falls.
- Focus on fundamentals of the company
One should be well aware of the fundamentals of the company before investing in a dividend stock. There is a possibility that to be in the eye of the investor, the company is paying good dividend but has a huge debt in its balance sheet. Many a times companies take debt and pay dividend from that amount. To solve this problem, one should consider the payout ratio of the company. If the payout ratio is high, its dividends are risky.
- Keep a good eye on valuations
Normally when an investor buys a stock based on dividend, he/she just looks at the dividends of the company and ignores the vital valuations, which should not be the case. One should always try to buy stocks with a significant discount or with a margin of safety of at least 10-15%.
- Don’t just keep one type of stock in the portfolio
If one keeps only high dividend yield stocks in their investing portfolio, a bulk of the investment would be focussed on a few sectors. It should be noted that one should have a well-diversified portfolio that can be feasible in different economic cycles. Experts believe that a lot of focus on one kind of stock can reduce the portfolio ability to generate income in the long term.
- Stay focussed on portfolio
Generally, investors who build dividend yielding portfolios, ignore the key happenings in the market. There are many events which can affect the performance of the dividend yielding stock. For example, if the competitor has decreased its prices, it may affect the margins of the company and in the future, it can affect the net profit of the company. The reduction in net profit will eventually affect the dividend of the company.
- Don’t forget the financial position of the company
Not paying attention to the significant financial position of the company and focussing only on the profit figures is a common mistake an investor often makes. Key metrics like debt to equity ratio, leverage ratios, net debt to EBITDA etc, are very important ratios to consider.
- Dividends are not interest
Many people consider dividends as interest. In the case of interest, the company has the obligation to pay interest no matter what. But the case of dividends is different. The companies are not obligated to pay dividends. It is the decision of the Board whether to give dividend in a particular year or not.
Ideally, firms which have a huge market capitalisation are the safest dividend paymasters, given that they better and more predictable profits generated. They thrive to maximize stakeholder wealth apart from concentrating on the overall growth of the business. Start-ups and high growth firms are known to not pay dividends, given their low disposable profits and future growth prospects.
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