Dylan Lewis: Hi, I'm Motley Fool analyst Dylan Lewis. On this episode of FAQ,
we're walking through what a dividend is, and what investors need to look for in dividend stocks.
When a publicly traded company has extra money on hand, it gives the management team some
flexibility and options. With that extra cash, they can: one, take that money and invest
it back in the business. They might decide to do that through expanding their existing operations,
building out factories, or possibly acquiring another company that can help them grow.
They can also, two, take that money and buy back shares of their own company.
This strategy reduces the number of ways ownership of the company is sliced up, increasing individual
ownership for shareholders. Or, they can, three, pay out some of the money to people
who own shares of the company as a way to share the wealth and reward them for owning
the business. If a company decides to go with number three, they'll issue a dividend.
A dividend is a payment from a company to its shareholders, and it often comes quarterly
but sometimes monthly. Typically, management will say, "OK, we're going to pay each shareholder
$X each quarter." So, every three months, each shareholder will receive a payment.
As an example, say you own 10 shares of my company. I decide to issue a quarterly dividend of $1.
Every three months, you get $10 in dividends, $1 per share times 10 shares,
or $40 over the course of the entire year. Now, people that own shares of the company
can choose to receive that in two different ways. They can take that money as cash and
do whatever they want with it, or they can decide they want to receive the dividend as
partial shares of the company they own. This is called a dividend reinvestment plan,
or DRIP. Often, folks that are looking to have investments generate income, like retirees,
will take dividends in cash. But for people looking to increase the size of their ownership
in a stock over time, reinvesting the dividend is a great strategy, as it helps them slowly
increase the number of shares they own. Understanding what a dividend is is one thing.
But it's important to realize what kind of companies tend to issue dividends and what
to look for as an investor. Going back to the three different options I mentioned earlier,
dividends are something that companies tend to do once they've put enough money aside
to fuel their own growth. Think about it -- if you have some new business segment that you
can invest in, wouldn't you rather put your money there and meaningfully grow your company,
rather than just pay money out to shareholders? For this reason, most dividend payers are
not high-flying growth companies, but more mature companies that have established businesses
with predictable sales. Think big companies like McDonald's, Coca-Cola, and IBM.
They're still investing in themselves, but often, more than enough money is left over to also
send some shareholders' way. These companies will start paying out because having a dividend
tends to attract income investors, or people that are happy to hold a stock over long periods
of time and simply collect payments. The company has to pay out shareholders quarterly,
but with that payment comes a lot of stability in the ownership of the business. For this reason,
companies generally only start paying a dividend once they're convinced they'll
maintain it well into the future. There are two important numbers to keep in
mind looking at dividends: dividend yield and payout ratio. Yield measures how much
you're receiving in dividends compared to how much it costs to buy the stock. The equation
for this would be dividend payment received over the price of the stock. Let's go back
to the example that I used before. My company pays a dividend of $1 every three months,
so owning one share earns you $4 per year in dividends. Now, let's say the current price
of one share of my company is $100. Four over 100 gives us a dividend yield of 4%.
Put another way, if the stock price is exactly the same one year out, you will have earned 4% on your
investment thanks to just the dividend. Over the past few years, the average yield
in the S&P 500 has been about 2%, but some stocks have yields of 4%, 6%, even 7%.
High yields may sound good, but it's important to be sure the company can maintain those
payments over time and that they're sustainable. That's why you also need to look at the company's
payout ratio. The metric may sound fancy, but all it does is compare the amount that
the company is paying in dividends against its annual income. So, it's dividend payments
divided by net income. If a company's payout ratio spikes, it means they could have to
reduce their dividend down the road, unless business results turn around. And if it's
over 100% it means they're paying out more in dividends and they're currently making,
which is a big red flag for investors. For people interested in dividends,
but are just beginning to invest, the dividend aristocrats are a great place to start. These are companies
from the S&P 500 that have maintained a dividend and increased the payment every year for at
least 25 years. It's an impressive feat, which is why only about 50 companies currently make the cut.
Running a few names off of the dividend aristocrat list -- Walmart, Exxon,
Johnson & Johnson -- it's clear why these kinds of companies make for great dividend stocks.
They have great, resilient business models that can weather economic downturns and continue
to reward shareholders. If a stock checks all those boxes, you can probably bank on
its dividends sticking around to keep paying you.
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