When most investors and traders purchase stock it is because they intend to profit from the rise in its price. They are familiar with the mantra: ‘buy low and sell high!’ But there are several other ways of profiting from the ownership of stock shares without having to part with them. In this article, we will examine dividends as an additional method of making money from stock ownership.
When a publicly traded company reports their quarterly earnings from operation, they will often decide to share some of the profits with the owners of the company. This is called a dividend. Whoever owns shares of the company is considered a partial owner of the company. In effect, a dividend is a way of receiving your share of the company’s profits.
Many investors look to dividends as a way of receiving a regular income from an investment portfolio. However, things in the business world can change drastically and knowing how to pick the right stocks to create that regular, dependable cash flow is very important.
One critical thing to remember is that if a company is paying a portion of its profits to shareholders, it may reduce the amount of money available for growing the business itself. Most dividend investors are focused on value rather than profiting from the rapid appreciation of the stock price. Remember, the money they pay you cannot be invested by them in operations.
So as a dividend value seeker, we should learn about a ratio called dividend yield. The dividend yield is a simple calculation and many financial websites provide this information freely. The dividend yield tells you how much cash flow you will be receiving for your investment in the shares. It is simply the dividend amount divided by the share price.
As an example, The Walt Disney Company (DIS), pays an annual dividend of $1.68. The previous close, as of this writing, was $99.42 per share. So, the dividend yield is 1.69% ((1.68/99.42) x 100 = 1.689). In the picture below, Yahoo Finance shows a slightly different yield number.
All other things considered equal, when comparing two companies as an investment you would generally want to buy the one with the higher dividend yield. This is considered getting more ‘bang for your buck.’ There are several screeners and maps of the market found online that can help you see which stocks carry higher dividend yields.
As mentioned earlier, business environment conditions change. This could affect the amount of the dividend paid out to shareholders. If the company’s business slows due to competition or economic reasons, the company may decide to reduce or eliminate the dividend altogether. To reduce the chance of this happening, investors should make sure the company is not paying out too much of its profits as dividends.
There is another ratio that investors should be aware of, the payout ratio. The payout ratio is expressed in percentages and tells an investor how much of the company’s profits are being paid to shareholders.
Looking at the financial data of DIS once again, we know the dividend is $1.68. The EPS is stated online as $7.01. So, the payout ratio should be 23.96%, ((1.68 / 7.01) x 100). But is this a good number? Well, it depends. If a company is paying out too much of their profits they may not be able to sustain that dividend when times get tough economically.
There is no set number for what would make a great payout ratio because it varies from sector to sector. Generally, over 50% would be considered high and potentially unsustainable. A 0% to 35% is generally considered to be good in the industry. 36% to 50% is ok and sustainable if there is earnings growth in the company. Higher ratios may be acceptable if other factors are in place within the operations of the company.
Overall, dividends are a great way to earn extra cash flow while holding an investment. Learn about them and how to select the correct stocks to invest and trade at Online Trading Academy’s register today for a free workshop.
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