How does a stock dividend work

How does a stock dividend work?

What’s a dividend?

Webster’s Dictionary defines a dividend as “an individual share of something distributed.” So how does a stock dividend work?

Companies sell portions of their business to investors in the form of stock shares in an effort to raise capital for various business initiatives. In return for their money, shareholders are looking to make money on their initial investment.

One common way that companies pay back investors is by offering a dividend payment.

How does a stock dividend work?

Dividend stocks work by an investor purchasing a share of stock in a publicly-traded company. By purchasing stock in that company, you essentially become a small-fraction owner of Company XYZ.

One decision that a board of directors votes upon is the company’s stock dividend payout. The stock dividend payout is a portion of the company’s earnings paid back to the shareholders.

Dividend payouts can be in the form of stock or cash, but most companies choose to pay cash.

Shareholders can then choose to receive the cash in their accounts or have it re-invested to buy more shares of the company. One benefit of reinvesting dividends is your earned money is put back to work by paying lower capital gains tax on “qualified dividends.”

What to look for in a dividend stock?

There are many different metrics to look at when determining whether a certain stock should be on your buy list. The following areas can be used to compare dividend stocks between each other.

Metrics for Comparing Dividend Stocks

Dividend Yield:

A stock’s dividend yield is the yearly dividend payout represented by a percentage of the current stock price.

How to calculate dividend yield:

Dividend Yield = $ Dividend Price / $ Share Price

AT&T stock has an annual dividend of $2.08. With the stock trading slightly above $29 per share, the dividend yield for AT&T is approximately 7.2%.

Payout Ratio:

A dividend payout ratio is an amount a company pays its shareholders in dividends compared to its net income.

Payout Ratio = Dividend per Share / Earning per Share

AT&T currently has a payout ratio of approximately 58%. A general rule of thumb is that Payout Ratios above 75% may be unsustainable for the long-term. The 40-60% Payout Ratio range is seen as a healthier percentage for higher quality dividend stocks.

Debt:

Another determining factor of a healthy dividend-paying company is by examining their debt-to-equity ratio. Debt-to-equity is a comparison of the amount of debt the company holds in comparison to its shareholder equity.

Debt-to-equity ratios that are >1.0 are seen as good. Generally a lower debt-to-equity ratio is considered a positive. Businesses operating with less debt allow spare cash to be put to work in other areas.

By examining AT&T’s history of debt-to-equity ratio, you can see that the company has been able to pay down some debt, but it is still not down to their 2012 debt-to-equity ratio of 0.5.

Being a shareholder of AT&T stock, this is definitely an area I will be closely watching in the future.

Profitability:

A company cannot continue paying out dividend money if they are not profitable over time. Sure, companies are going to have bad quarters or maybe even bad years, but they will need to find their way back to making a profit in order to survive.

To measure profitability we can examine a company’s net margin. Net margin is a measure of what a company keeps as profits compared to its net revenue. Operating with larger net margins allows companies breathing room if their business runs into rough patches.

A company with a net margin of less than 5% is operating in dangerous territory in terms of not being profitable. Selecting dividend stocks with higher net margins may help ensure their payout is reliable.

Dividend History and Growth:

When talking about dividend growth there are two things to watch for in particular. The first is a company’s years of consecutive dividend increases. The second, the annual growth rate of the dividend increase.

Companies with a history of dividend increases are seen as reliable operators. Savvy companies with responsible money management can go years with consecutive dividend increases.

In fact, some of the better dividend companies have 25+ years of consecutive increases. To make the Dividend Aristocrats List, a company must be in the S&P 500 and also have 25+ years of consecutive increases.

A good starting point for selecting stocks would be to look for at least 10-15 years of consecutive dividend increases.

Companies with healthy dividend yields between 2.0-6.0% can hopefully offer dividend increases of between 5 and 10% each year. The higher the dividend yield, the lower the growth rate will most likely be.

As a shareholder, you may be able to live with smaller growth rates if a stock offers a dividend yield on the higher end of that spectrum.

In Conclusion

If you are serious about increasing your net worth, passive avenues such as dividend investing may be a great option for you.

A few things to remember about dividend investing:

  • Research your picks thoroughly. (Do not rush into a stock you are unsure of.)
  • Realize dividend income is not a get-rich-quick plan.
  • Re-invest your dividends for maximum gains. (Snowball-like effect)
  • Re-investing your dividends may help lower your capital gains taxes.
  • Do not fall into the yield trap. (Companies in poor financial shape offering extremely high and unsustainable yields)
  • Do your research, if a ridiculously high yield seems too good to be true, there’s probably an underlying reason why!

Good luck, you got this!

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