Why do investors look for dividend stocks?

Summary

• Dividend stocks are companies that offer regular dividends to their shareholders. In general, well-established businesses offer dividends consistently.
• Companies generally pay dividends in the form of cash. However, companies also provide an option to their shareholders to reinvest their dividend amount.
• In times of certainty, like the COVID-19 pandemic, lure investors, in search of regular income, towards dividend stocks.
• Dividend yield, EPS, P/E, and capital gains are some factors that investors consider before investing in dividend stocks.

Dividend stocks are those companies that provide dividends to their shareholders consistently. Generally, well-established corporations opt to pay out dividends regularly.

Investors generally look for dividend stocks as they offer a stream of income above the growth in a portfolio's market value.

What is a dividend?

A dividend refers to the distribution from a Company's earnings to the shareholders. The Board of Directors decide these payouts.

A Company provides dividends, in cash or additional stocks, to its shareholders as a reward for investing their hard-earned money into the business.

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How do dividends work?

As highlighted above, a dividend is the cash payouts that the Company provides to its shareholders from its earnings.

While, Companies mainly provide dividends in the form of cash, there are instances where shareholders are given an option to reinvest the dividend into the Company. These Companies believe that they could make better use of the dividend amount to grow their business, and the investors can benefit from the stock price appreciation.

Dividends are more sought-after during times of high volatility as investors aggressively look for ways to earn regular income.

Different types of dividends paid out to shareholders?

There are generally four types of dividends. The most common is the cash dividend, where, as the name suggests, the companies provide dividend in cash. These cash dividend could be ordinary or qualified. In an ordinary dividend, the shareholders are taxed at the income tax rate. On the other hand, the qualified dividend is taxed as capital gains.

Other than a cash dividend, other forms include stock dividend, asset dividend and special dividend.

Stock Dividend: Stock dividends represents dividend payouts in the form of shares.

Asset Dividend: Asset dividend could pay in the form of an asset like property.

Special Dividend: These are occasional, one-time cash payouts that the Company might pay to its shareholders.

Key metrics investors consider while investing in a dividend stock

Dividend yield

Dividend yield measures the amount of dividend the Company is paying to its shareholders annually in relation to its current stock price. The formula for calculating dividend yield is:

Dividend Yield= (annual dividend per share/current market price of the share) X 100

If a Company's stock price is US$100, and it pays an annual dividend of US$10, the dividend yield would be 10%. This is considered a good investment. However, sometimes increased annual dividend could be an alarming sign. This is because the increased annual dividend could be a possibility because of the falling market price of the share.

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Hence, investors do find the reason for increased dividend yield before investing in these stocks.

To know about the Top 25 Stocks by Dividend yield in Australia, click here.

Payout ratio

Payout ratio refers to the proportion of earnings paid to shareholders compared to the Company’s net earnings. The ratio tells the shareholders the amount of money the Company is paying and the amount it keeps to repay debts, reinvest or add to its cash reserves.

Through the dividend payout ratio, investors try to analyse and select the companies in sync with their investment objectives.

Total return

An important parameter that investors look at in dividend stocks is the total return they might receive by investing in such stocks. Total return comprises an increase in the stock price (capital gains) and the dividend paid. Capital gains are a portion of the total return on investment due to an increase in the market price of the share.

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If a stock were purchased at US$100 a year ago, and the current price is US$120, the capital gain would be (20/100) X 100, or 20%.

On top of that, the Company pays an annual dividend of US$4, then the capital gains above investment would be (4/100) X 100, 4%.

Hence total return from investment would be 20% + 4% = 24%.

EPS or earnings per share

Earnings per share is another component that investors look at while selecting a dividend stock. Dividend-paying companies that show constant growth in their EPS and increase in dividend are the ones more preferred by investors looking for dividend stocks.

P/E ratio

P/E ratio is also one factor which investors look to check whether the stock is overvalued or undervalued. The ratio is calculated by dividing the market price per share by the EPS of the Company.