The continuance of a dividend is never assured, but there are a number of things the investor can examine that will offer confidence of the dividend’s survivability, or act as a red flag. We examine these metrics, look at some example companies, and link to sources where this information can be found for any company.
My wife saw an advertisement on television for a peeler. It showed someone peeling apples, pears, carrots, and on and on. As this had been one of her frustrations in the kitchen she ordered it, saying that it would change her life.
When it arrived, to be gentle, it did not exactly work as well as advertised. I tried using it myself with as little success as she had had. Today it is in the basement, in a box of things we would like to give away, but wouldn’t want to burden anyone with.
Purchasing on a promise is that we do. We buy things because they promise to help us in some way. Sometimes they do, sometimes they do not. When we purchase something with the hope that it will help us and it does not, we know that if we had had that knowledge beforehand we would not have made the purchase in the first place.
Dividend stocks are in the same category. When researching a company we look at the expectation of future growth, we look at the expectation of stability, and we look at the expectation of the dividend. As we look at financial statements there are indicators with each of these aspects, and as the first two are outside of the scope of this writing, I will focus on the dividend.
This is essential because if there are red flags implying a possible cut or removal of the dividend, then the only path forward is to value the company without this key aspect. As dividend stocks rely on this quarterly payout to attract and hold investors, valuation without the expected dividend will almost certainly mark the company as a sale.
There are a number of metrics that we can examine that will give us an indication as to what we should be looking for. We will also look at a few companies to see how they are evaluated through these metrics.
Dividend Payout Ratio
The Dividend Payout Ratio is the most commonly used metric. It is expressed as a percentage, and is found by dividing the annualized dividend per share by the earnings per share. This shows the percentage of the company’s earnings that are shared with the investor through dividends. (The opposite of this would be the retention ratio, which is the percentage of earnings that are not given to shareholders, but are retained by the company.)
The two obvious endpoints come with payout ratios less than 0% and higher than 100%. The former can happen if estimates of earnings per share for the next year are negative, meaning that the company is losing money. If the company is losing money then it has no business going further into debt by offering a dividend.
When payout ratios exceed 100% the company is making money, but more dividends than earnings are going to the shareholders. This is not a sustainable event. It is possible that a company with a long history of dividends may not want to cut or suspend the payments, and if a one-time event (lawsuit, catastrophic event, etc.) is the source of payout ratio then they may allow this to happen, but it is not a positive trend.
Payout ratios over 50% are considered to be high. From the investor’s point of view a ratio this large might be a positive event. But for the long term investor it means that the retained earnings may not be enough for the company to sufficiently invest in future growth, which could then stunt the ability of the company to increase dividends in the future.
A payout ratio over 75% trends toward the more severe end. A lack of future growth not only puts dividend increases in the future into jeopardy, but the company’s stock can drop as a result, subjecting the investor to the worst of both worlds.
The Dividend Payout Ratio is easy to find. NASDAQ.com offers the information on their website – here are links to three companies in my dividend portfolio where I have owned DRiPs an average of 20 years, MMM, Aflac and Johnson & Johnson. As can be seen from these three companies, the payout ratio is in the area of comfort.
Dividend Payout Ratio
Johnson & Johnson
Cash Dividend Payout Ratio
The Cash Dividend Payout Ratio is similar to the Dividend Payout Ratio, but provides a better analysis of the sustainability of the company’s dividend. Instead of comparing dividends to earnings, the dividends are compared to cash flow, so the formula looks like this:
Preferred dividends are given to shareholders of preferred stock, which basically means that they have priority over holders of common stock. If a company is unable to pay all of their dividends then those with preferred shares are first in line to get theirs.
At first glance this may seem to be a number that would pretty much be the same as the Dividend Payout Ratio, and in a perfect world that would be the case. The difference is that earnings can be manipulated considerably easier than cash flow.
Earnings manipulation is not necessarily intentional fraud, but can be performed through legal accounting tricks that make the company appear to be more profitable than would otherwise be the case. Obviously, the more earnings a company shows, the more positively it is viewed. Examples of this manipulation could be capitalization practices, modifying the timing of operating activities, and merger-related expenses.
Cash flow is the movement of money in and out of the business. While it is possible to manipulate cash flow, it is much more difficult, so using cash flow instead of earnings in the equation can offer a more reliable number.
For these three excellent companies we see a wide range with the cash dividend payout ratios. I generally look to the guidance noted above as far as what might be considered to be high and low.
MMM’s Cash Dividend Payout Ratio appears to be on the high side, but no number should be seen in isolation. Information of this sort should not be used by itself to make a decision but should be seen in conjunction with additional information to determine its relevance. In this case MMM’s number is something to note and keep in mind while investigating other information.
MMM has increased their dividend every year since 1959, weathering seven recessions, so it would be extraordinary if they were to decide to end this streak. As this is a company that has historically placed importance on maintaining their dividend, the expectation is that they will continue to do so. We need to make sure that they actually will be able to do this.
Financial Debt Ratios
Financial debt is simply money owed by the company that is to be paid back at a future date. This could include short term debt (due within one year), long term debt, deferred revenues, pension liabilities, and many other items.
Debt is not necessarily a bad thing, after all one might go into debt to purchase a car, which in turn could make it possible for the individual to travel further for a higher paying job. The same is true with companies – properly structured debt can be used to the company’s advantage (for instance, paying 4% interest on something that offers 6% in return).
Certainly, too much debt can cause major problems. The required outflows of money limit the amount that can be used for investing back into the company, as well as dividends. Understanding the ratio of debt to certain other issues gives us an insight as to how the debt is affecting the company.
Debt to EBITDA
EBITA stands for Earnings Before Interest, Taxes, and Amortization. While EBITA is not recognized in the generally accepted accounting principles, it is a commonly used number that generally references the company’s operating profitability. Comparing the debt to profitability gives us an indication as to how much the debt is dragging on a company’s earnings.
While MMM has the highest in this small group, the Gurufocus’s MMM page also indicates that while MMM’s debt to EBITA ratio is at a 10 year high, this number is ranked lower than 55% of the 1,843 companies in the Industrial Products category, so that should be taken into consideration.
Interestingly, Aflac and Johnson & Johnson both rank higher than 51% and 59% of the companies in the Insurance and Drug Manufacturers industries.
Debt to Assets
A comparison of debt to assets offers an indication as to how much the company’s assets are leveraged after accounting for their securities. A ratio of 0.5 or larger might be a cause for concern, but the industry in which the company fits under has much to do with this number. After all, a company that makes products to sell (like MMM) would have many assets, whereas an insurance company (like Aflac) would have considerably fewer.
While I do not consider this ratio to be as significant in terms of a dividend’s stability as the above numbers, it is valuable in that offers an insight to the degree which the company is using debt to finance its assets. In other words, a number of 0.3 means that 30% of its assets are financed through debt while 70% is owned by the shareholders.
Not only is MMM’s number high, but it is also high when compared to other companies in the same space. As stated above, these numbers should not be viewed by themselves, but in coordination with other numbers. When looked at together the company’s high Cash Dividend Payout, Debt to EBITDA, and Debt to Asset ratios together must make one take notice of their situation.
Delving further into the numbers, we see that MMM is currently saddled with $14 billion in debt, which even for a company of its size is substantial. Chances are that this company’s dividend is safe, but the data points noted should make holders of the stock pay closer attention to the quarterly reports. In this case I would suggest that MMM is neither a green flag nor a red flag, but more a yellow one, or caution. I have confidence that they will do what they can to continue to increase the dividend well into the future, but need to continue to monitor the situation to make sure that events do not overcome the company’s desires.
Evaluating companies to ensure that their dividend is secure is important and necessary for owners of dividend stocks and those thinking about a purchase. The company’s dividend is an essential part of the reason for owning the stock, and making sure that the dividend is retained will bring stability to one’s portfolio.
There is a big difference between qualified and unqualified dividends, and that difference could determine whether or not one will pay taxes on them.
There is no getting around taxes. It hits us each year and each year it is a double whammy – not only does money go away, but there is frustration in simply figuring out how much is to go away. One need to somehow find ways to make an utterly dismal task palatable.
One of the few smiles possible is that of finding that one is able to take advantage of a tax break. Tax breaks are not only for millionaires and billionaires, but can be found for the small investor. That is the case when considering qualified and unqualified dividends, and that is why we need to understand the difference between the two types.
The good news is that most stock dividends fall into the category of qualified dividends. To be classified as a qualified dividend, the IRS lists three categories, each under which the dividend must fall.
The dividends must have been paid by a U.S. corporation or a qualified foreign corporation.
There is a list of about 75 countries with which the United States has an income tax treaty. I find it interesting that in addition to Russia being included, so it the USSR (I thought they went away in the early 1990s). It is almost certain that the company in which one is investing will be covered within this group.
The dividends are not of the type listed later under Dividends that are not qualified dividends.
This is one of those non-helpful descriptions one often gets within government documents. Generally speaking, what they are talking about are special cases, like dividends from cooperative banks and credit unions that should be reported as interest income, dividends from tax-exempt organizations, and a handful of other issues that are not common.
You must have held the stock for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date.
This is a more common situation for investors who are trading stocks more frequently than the long term investor. One must have owned the stock for a required amount of time around the ex-dividend date. In this case, the holding period starts 60 days before the ex-dividend date and ends the 60 days after. Within this 121 stretch of days, one must have owned the stock for at least 61 of those days.
As an example, one purchases shares of a company on July 5, the ex-dividend date is July 12 and the shares are sold August 8. The dividends the investor received would then not be considered qualified dividends because the shares were only owned for 34 days. If the investor had held the shares until November 1 then they would have been owned for more than 60 days within the May 13 (60 days before the ex-dividend date) – September 10 (60 days after the ex-dividend date) timeframe, thus the dividends would be considered to be qualified.
And yes, as always appears to be the case, there are exceptions to this, but they are rather uncommon.
Unqualified dividends are alternatively called common dividends. Generally speaking, these are dividends that do not fall into all of the three categories outlined above. There are some categories like REITs, employee stock options, dividends from money market accounts, and special one-time dividends that designate them in the unqualified category, but for the most part, if one is purchasing dividend stocks for the long term then almost certainly all dividends will be considered qualified.
The information for each company and mutual fund as to the total amount of dividends for the year and the amount that is qualified is listed on lines 1a and 1b on the 1099-DIV that is received at the beginning of the year.
The reason that the distinction between these two types of dividends is so important is that they are taxed differently. Nonqualified dividends are taxed at the capital gains rate. This means that there is no difference (tax-wise) between dividends that are considered nonqualified and regular income.
On the other hand, qualified dividends are taxed at a lower rate – if at all. If a single filer receives $39,375 or less in qualified dividends then those dividends are tax-free. Joint filers get to collect up to $78,750 without having to pay taxes on those dividends.
2019 Single Filer Tax Brackets
Income Tax Bracket
Income Tax Rate
Capital Gains Rate
$0 – $9,700
$9,526 – $39,375
$39,376 – $39,475
$39,476 – $84,200
$84,201 – $160,725
$160,726 – $204,100
$204,101 – $434,550
$434,551 – $510,300
2019 Joint Filer Tax Brackets
Income Tax Bracket
Income Tax Rate
Capital Gains Rate
$0 – $19,400
$19,401 – $78,750
$78,751 – $78,950
$78,951 – $168,400
$168,401 – $321,450
$321,451 – $408,200
$408,201 – $488,850
$488,851 – $612,350
The charts for the 2020 tax year are scheduled to allow for slightly higher income tax brackets, so the single filer will be able to receive up to $40,000 in dividends and joint filers will be able to receive up to $80,000 without having to pay taxes on the dividends.
As can be seen from the charts above, this makes for a very strong retirement strategy. If a single filer were to have a million dollar portfolio of dividend stocks offering an average dividend yield of 3.5%, it would result in $35,000 in dividends that would not be taxed. If the filer needed $50,000 during the year then that $15,000 of non-dividend money would be taxed at a lower rate than if the entire $50,000 came outside of dividends. Joint files would double those amounts.
It is clear that there is a huge tax advantage to ensuring that dividends are qualified. The stream of cash from qualified dividends is almost like taking money from a Roth IRA unscathed by taxes. When I start the chore of working on my taxes in March I will be grumbling until I get to the part where I report my dividends, knowing that that income will pass through without being touched by the taxman.
Most people start investing without having the proper foundation in place. There are five tasks that should be accomplished before getting involved with investing.
Perhaps by the title you were thinking that I might be cautioning against investing at this particular time. For some that is exactly what I am saying, but it has nothing to do with market prognostication. After all, with proper dividend investing, timing is of little significance, but that is fodder for a different article.
I occasionally participate in the Quora forums, where people ask and answer questions. Within the dividend realm there are numerous questions that can only make one shake their head in despair. For instance:
How can I make 8 million dollars?
Is there a proven way that you have used to get rich using other people’s money?
I am desperate to get rich, what can I do?
What is the best way to make a million dollars?
And the amusing:
Is there a way to get rich without risking jail time?
When I think back to a time when I was much younger I can imagine myself asking these very questions. With the current success of the stock market (this is written in January 2020, so keep that in mind) it is natural to think that just throwing money in that direction will result in financial success.
Stepping back a couple of decades this could have been the situation. The craziness of that time could be represented by TheGlobe.com, a social networking site. It went public in 1998 and the shares jumped over 600% on its first day of trading.
Perhaps we know what happened from there – the price fell to ten cents, the company went out of business, and today their website cannot be reached, thus the reason why the link to it above goes to Wikipedia. Many people made money during that time, and many people lost money.
The investing mindset is a key component to prudent investing. Throwing one’s money into the air with the expectation of success is something that simply does not work. Building a proper foundation before one begins to invest not only sets a proper framework from which to build success, but also establishes the proper mindset that keeps one from delving into penny stocks and get rich quick schemes.
There are five tasks that should be performed before beginning to consider the selection of companies for their portfolio. While these items may take quite a bit of time to perform, they will act as preparation for the investment of one’s hard earned money.
1. Get rid of all credit card debt
There is good debt and there is bad debt. Good debt goes toward a specific objective that one can use to better their life. Education can put one into debt, but the degree that the education offers will allow one to get a better job. A car may put one in debt but it is probably necessary to get one to work. A house will almost certainly place one in debt, but the structure becomes equity.
Bad debt results from not being able to afford what has been purchased. I use my credit card on a regular basis because I get cash back, but pay the card in full when the bill is due. If I could not do this then that would indicate that I am spending too much (or not earning enough). Not being able to pay off a credit card is financially unsound and acts as a negative investment.
2. Max out any matching funds that your employer offers
Even better than sliced bread is the opportunity to invest in an employer’s 401(k) or equivalent. The money is taken from the paycheck before taxes so one’s overall taxes are lessened. These funds are eventually taxed at a time when the tax rate is almost certainly lower.
If the employer offers a match of any money invested then that percentage should be maxed out. Some employers offer up to 7.5% matching of funds. Whatever the employer is willing to offer, that is what is referred to as “free money” and actually an untaxed (at the moment) increase in salary.
3. Open a savings account and add to it until you have three months of money
I seldom suggest placing money into a savings account but this is an exception. The interest rates on savings accounts are such that one actually loses money over time due to inflation. A savings account, however, has the guarantee of retaining the amount entered. The same could be said of a money market account or CD (although one needs to make sure that they will not need the money before the CD matures, a mistake I made long ago). Any instrument that insures the amount will suffice.
The reason for doing this is insurance against the peril of losing one’s job. In my working life I was laid off more times than my wife had jobs – just the hazards of being a programmer – which is perhaps why I see this as imperative. The last thing you want is to have to pull your money from working investments at a time not of your choosing. This reserve will give you three months of confidence that the rent will get paid, you will have food to eat, and will enjoy heat in the apartment or house.
4. Open a Roth IRA
This also falls into the category of “free money.” A Roth IRA allows one to invest for retirement, and when the time comes there are no taxes on the capital gains. I wish that this had been available when I was younger, but when it was offered I maxed it out.
One can place up to $6,000 a year ($7,000 a year if 50 or older) into the Roth IRA. For example, if over 20 years one invests $120,000 into the Roth and the investment grows to $300,000, that $300,000 can be pulled out at the age of 59½ without having to pay taxes on the $170,000 in capital gains. Like I said, free money.
The ability to withdraw the money tax-free is not only great in itself, but can also be used as a means of minimizing taxes when combined with extracting taxable monies from one’s account. It is an all-around win.
5. Maintain a budget
It is easy to be surprised with things like car repairs, which (of course) always happen at the worst times. It is much better to know that at some point one’s car will need to get repaired, so if money has already been set aside for this eventuality then the hit is not as severe.
For my budget I use a simple Excel spreadsheet and have categories like Electric, Car, For my budget I use a simple Excel spreadsheet and have categories like Electric, Car, Cable, etc., as well as things I am saving for (vacations, music festivals, etc.). Each month I add money to each month’s row and remove what was spent that month in that row. I know what is coming in and what is going out so that I don’t get in trouble. If you want to use the spreadsheet I am using and modify it to your own needs then I have made available an example spreadsheet, but anything that works can be used (I started long ago just using graph paper).
At this point one can think about investing.
For some this may sound like a lot of unnecessary steps, especially when one sees a booming market and wants to jump in and make money. But there are two things these steps do.
The first is that they establish a foundation of financial stability. One has no debt, has taken advantage of the obvious and simple means of getting “free money,” has financial stability in case of the loss of money coming in, and understands their cash flow. With the last item in this list one will know how much they can afford to invest and remain financially stable.
The other thing is that these steps provide the proper mindset for investing. There are no questions about how to get rich quickly, no temptations to speculate on penny stocks, and no lack of understanding what it takes to be financially independent. The hard work that it takes to perform all of these steps makes one even more cautious when it comes to investing their hard-earned money, and better prepare one to truly become a prudent investor.
For the dividend investor, Dividend Champions are an essential part of the portfolio, and solve the primary problem with investing in dividend stocks.
Dividends are a distribution of profits, where a company’s board of directors decides to give its current shareholders cash from the company’s profits. They offer the investor, often quarterly, cash in proportion to the number of shares owned. This helps with the issue of risk associated with owning the stock, as the investor receives cash in lieu of hopeful results at a later time.
In researching why some argue against including companies that offer a dividend within one’s portfolio there are a number of recurring issues. For instance, some say that there may be a tendency for the investor to chase high dividend yields. I will explain below the risk of looking only at that single aspect of a company and for now note that proper diligence always needs to be performed by any prudent investor.
It was also noted that companies that pay dividends are not usually high-growth leaders. High growth companies normally retain their earnings so that they can be reinvested back into the company, so their profits are better used that way. Of course, there are exceptions, like Microsoft and Apple, but generally speaking companies that offer a reasonable dividend offer what are considered to be value stocks.
The reason to not invest in companies that offer a dividend
There is one legitimate reason to not purchase companies for the dividend and that is that dividends are not guaranteed. One might see that a company has offered a specific dividend in the past but that dividend can be cut or even discontinued. There are numerous examples of this problem.
General Motors was a reliable company for many years, but in the mid-2000s they hit a snag. As the price of the stock fell, the dividend yield shot up to 10%, which sounded like a very attractive offering. After all, making an easy 10% on one’s investment is an attractive possibility. However, as oftentimes is the case, this was not something that could last long, and in 2006 the dividend was cut in half. Two years later the dividend was suspended completely.
Imagine regularly going to an amusement park where a particular ride is the big attraction, one that you ride each time you visit. Then the park announces that they have removed the ride. With your favorite ride no longer available, not only will you probably decide to go somewhere else, but that will also be the case with many people. So with fewer people going to the park, less revenue is collected, more rides may close, and the cycle could continue until the park closes.
The same sort of thing can happen with companies that cut their dividend. Since the dividend is part of the calculation one makes when evaluating a stock, if the dividend is cut or removed then there is more reason for people to sell, less reason for people to buy, and a certain drop in the value of the stock.
As dividends are not certain, the risk factor that the dividend may be cut makes the dividend less attractive. This risk factor needs to be taken into consideration when evaluating a company, so that 2.5% dividend yield one might be counting on could get cut in half, or worse.
The solution to the problem of investing for the dividend
Although past performance is not surety of the future, a long history of positive dividend growth can give one confidence that there is a greater chance that the performance will be retained. A company that has offered a dividend for only a few years cannot give us certainty as to what might happen to the dividend in the future.
A company that has not only maintained a dividend but has also increased it every year for at least 25 years can give one confidence that this is something that is more likely than not to happen far into the future. The only question is how to find these companies.
Back in 2007 Dave Fish began to offer a spreadsheet that listed companies that met this criteria and called them Dividend Champions. With his passing in 2018 the task was given to Justin Law, who now maintains the list. Over the years the list has expanded to include not only companies that have increased their dividend for at least 25 years, but also Contenders (10 to 24 years) and Challengers (5 to 9 years). Each list also comes with a wealth of statistics for each company.
We are at a point in time where the past 25 years have experienced the Dot-com Bubble and the 2008 Stock Market Crash. Both were major events that placed a huge burden on companies and especially with the latter, there was every reason for a company to at least not increase their dividend. However, the Dividend Champions in today’s list continued to raise their dividend even throughout these crises. That fact can give one increased confidence that these champions will continue to increase their dividend in years to come.
An alternative to Dividend Champions are the Dividend Aristocrats, which are limited to members of the S&P 500 index. This is a list of companies that are filtered to include only the 500 largest companies in the United States stock market.
Dividend Champions are limited to companies in the United States, but over the years others have decided that companies outside the country should also be noticed so The DRiP Investing Resource Center includes:
Canadian Dividend All-Star List
European Dividend Champions
Eurozone Dividend Champions
Dividend Champions solve the primary concern of buying companies with dividends by offering a list of those that have not only maintained, but increased, their dividend for at least 25 straight years (more than 25 companies have a streak of at least 50 years!). With this history of dividend increases, Dividend Champions reduce the risk to the dividend investor associated with maintaining the dividend.
Allowing children to invest is less about the eventual financial returns, and more about learning to succeed financially.
About 25 years ago I decided to have each of my two children select a company in which I would purchase stock. I wanted them to understand that saving money was a good idea, and investing while saving was an even better idea. It was essential that they learn the evils of credit card debt and understand how to create and use a budget.
I asked my son, who was 12 at the time, what company he wanted to invest in and he said, “Nintendo.” I explained that the company was not on the US stock exchange so he would have to select another company. He said, “Playboy.” I told him that I doubted that his mother would allow him to read the annual report. He finally settled on Hewlett Packard and his sister selected Pepsi.
The great thing about dividend investing for children is that they have got time, so the power of compounding will be especially powerful for them. Seeing a savings start with a small amount and then increase over time gives them a sense of understanding what investing is all about.
The selections resulted in a competition to see which stock was doing better, and since this was the mid-1990s my son won on a regular basis, as the Internet was starting to take hold. More importantly, the competition gave them an awareness of how money can be used, and if done properly, how investments can increase in value.
I purchased the stocks in my own name and they were held in my own account. I wanted the proceeds to go toward their education – I did not want them to decide to blow the money on something they might consider to be imperative and I might consider to be frivolous. When the time came for them to go to college I sold the stocks and used the proceeds for tuition (although I did hold one share of Pepsi aside and set my daughter up with a DRiP). Others might choose to have their children actually own the stocks, and that is a direction of choice, which actually has some real advantages.
Minors cannot buy stocks. This is because one cannot legally enter into a contract until the age of 18. Some states like Alabama, Delaware and Nebraska set the minimum age to 19 and in Mississippi the age is 21.
To have children be the actual owners of the stocks one would need to set up a custodial account. In this case the child owns the stocks while the parent (or designated custodian) is in control of the account. Once the child becomes of age (18 -21 depending upon location) the assets come under his or her control.
As far as taxes are concerned, the first $1,050 of earnings are not subject to federal taxes, and in those early years the earnings would probably not reach that point. Also, the account qualifies for the $15,000 annual federal gift tax exclusion.
A number of discount brokers can handle custodian accounts. For instance, E*TRADE offers custodial accounts without commission or account minimum. Ally Investment also offers managed portfolios, so there are many options available.
The exciting thing about selecting dividend stocks is that four times a year money is sent from the company to the account. Many brokers can automatically reinvest those dividends so that the number of shares increases over time. It is the gift that keeps on giving.
So if you decide to establish a custodial account:
Select a broker that:
can make purchases without cost,
have no account minimum,
can reinvest dividends automatically.
Help your child select companies that interest them, you can also select companies that interest you and add them to the account.
Try to establish regular contributions to the account, however small.
A custodial account is a convenient means of giving a child a head start in the financial world. You are in control until the child comes of age, and both you and the child enjoy tax benefits.
Understanding the definition of the dividend yield is the easy part, what it means to the dividend investor is a matter of the current inflation rate and the reasons for purchasing a company.
When evaluating stocks there are many metrics that can be used, some have great importance, and others have importance only in specific cases. The dividend investor looks at the yield to understand what their cut of the proceeds will be.
Understanding the definition of the dividend yield is fairly simple, understanding what the yield means to the investor is another issue.
The dividend yield is the amount of the annual dividend payment divided by the stock price expressed as a percentage. For instance, one of my favorite companies, AFLAC, offered quarterly payouts in 2019 of 27 cents each, so for every share owned, $1.08 was returned as a dividend. AFLAC’s stock price, as I write this (21 Dec 19), is $53.14. So $1.08 / $53.14 *100 = 2.3%, the dividend yield.
As the dividend yield is a comparison with the price, if AFLAC’s stock price moves up to $60 then the dividend yield will fall to 1.8% or if the price drops to $50 then the yield will rise to 2.16%.
Related to this is the dividend payout ratio, which is also important to understand. The dividend payout ratio is a ratio of the total amount paid in dividends to the net income. When a company makes a profit, that money goes toward dividends, debt reduction, cash reserves, and reinvestment back into the company. The dividend payout ratio gives one an idea how much of the profit is being returned to the owners of the company, as opposed to being used for company purposes.
Understanding the implications of the dividend yield are much more difficult than understanding its definition. After all, dividend yield is just a number, but how does one know if it is a good number. And is there such a thing as a good dividend yield?
Unfortunately, the answer is one that we all too commonly hear – It Depends.
Reflexively one might think that the higher the dividend yield the better, after all, the higher the yield the higher the return. But reality pokes its finger into this thinking when one realizes that the highest average dividend yield ever was during the Great Depression, not one of the favorite times for investors.
Thinking about the reason for a dividend in the first place might offer a hint as to what a good yield might be. Companies oftentimes offer dividends to attract investors and create a demand for their stock. This means that the dividend yield needs to be attractive enough to convince the investor to purchase the company’s stock.
If one if looking for a place to put their money where it would offer a return, saving accounts and money market funds offer so little that the only value they have is that the funds are ensured not to go down. Of course, as of this writing the average money market interest rate is 0.18% and the inflation rate is 2.1%, so one actually loses about 1.9% with such an investment.
But that gives us an idea as to what the minimum dividend yield should be if one is purchasing the company solely for the dividend. If the dividend does not keep up with inflation then one could actually lose money while gaining it.
With the current inflation rate of 2.1% that might be a good starting point for what one might consider to be a “good” dividend yield.
However, as stated above, this would be the case for one who is purchasing only for the dividend. The company’s stock price should also be taken into consideration.
There is no magic formula for this – actually, some tout such formulas but I have seen these claims fall apart too many times. Due diligence for company selection is beyond the scope of this dividend website, but I can offer a bit of research I have found helpful.
Although past performance is no guarantee of the future (how many times have we heard that, and it is true), I do like to see where the company has been, and I will use the example of AFLAC.
Looking at the historical stock price of this company we can see that over the past 10 years the average annual return with dividends reinvested is about 11%. Since the company’s dividend yield is about 2% we can see that even if it was considerably lower, this would be an excellent company to select. The fact that AFLAC is a Dividend Champion gives one confidence that the dividend has an excellent chance of sticking around in the future, which also speaks to the stability of the company.
Comparing the dividend yield to the current inflation rate is a good starting point for one when considering the purchase of a company when the expectation of the dividend is a major reason for the purchase.