What is dividend investing?
Dividend investing is building an investment portfolio of stocks with the main goal of
“harvesting” dividends.
Let’s take the main two elements of this definition of dividend investing, stocks and
dividends, and define those as well.
A stock is a type of investment that represents the ownership of a fraction of a corporation.
A dividend is a payment made by a corporation to its shareholders, usually in cash, and
usually as a distribution of profits.
Dividends are generally seen as a sign of corporate maturity and balance sheet strength.
How do you start dividend investing?
Here’s example number one.
You could take the companies in the Dow Jones Industrial Average, and start from there.
Here are all 30 companies that are currently in the Dow Jones Industrial Average, a stock
market index of 30 prominent companies listed on stock exchanges in the United States.
I hope some of these companies are familiar to you.
Of the 30 companies, 27 are paying dividends, which is not surprising, as most of these
companies are mature and generate a lot of cash from operations.
For each of these 27 dividend paying companies, it is easy to find their current dividend
yield online.
For example, for 3M, at the time of making this video, the dividend yield was 4.1%.
Dividend yield is the annualized dividend divided by the share price.
This expresses how attractive the dividend paid is, relative to the share price.
After all, in dividend investing we are aiming to build an investment portfolio of stocks
with the main goal of “harvesting” dividends.
An important thing to check is: can the company afford to pay its dividend?
To answer that question, review the free cash flow the company generates.
Free Cash Flow is that part of the total cash flow that is not required for operations or
reinvestment.
You can calculate free cash flow from the numbers in the cash flow statement in a company’s
annual report.
For 3M in 2021, cash from operating activities was a cash inflow of $7.5 billion, capital
expenditures a cash outflow of $1.6 billion, and therefore free cash flow $5.9 billion.
Total dividends paid were $3.4 billion, so the free cash flow was easily able to cover
the dividend payout.
Follow-up questions to this are: what are the expectations for future free cash flows
and future dividends?
Do you feel comfortable that free cash flow will continue to be able to cover dividend
payouts?
And is paying a dividend the best way for a company to use its cash?
Dividend payments are not the only thing that happens to shareholders.
Every investor should realize that every stock moves up and down, which is easy to detect
with hindsight.
In the case of 3M: if you bought at $192 and sold at $259, you made a 35% return, which
makes the 4% dividend yield pale in comparison.
And if you bought at $219 and sold at $125, you lost 53%, which makes the dividend yield
pale in comparison.
Back to the 27 companies in the Dow that pay a dividend.
Which ones of those are the top dividend payers, in terms of dividend yield?
The average dividend yield for these 10 companies is currently 4%.
If you invest $10,000 (10 times $1,000), you should get $400 in dividend per year.
Should… as historical returns are no guarantee for the future.
Is it possible to live off dividends?
Harvest so much dividend through dividend investing that you could live off that passive
income alone?
Let’s calculate a scenario.
If you need $5,000 per month, then that equates to $60,000 per year.
Divide by 0.04 (which is the 4% dividend yield we hope to get).
You would need an investment portfolio of $1.5 million in high dividend yield stocks,
in order to generate the $5,000 dividend income per month.
$1.5 million is a sizeable investment portfolio.
What if you aim for higher dividend yields?
What investment portfolio is needed to generate the same level of monthly dividend income?
If we assume 6% dividend yield, then $1 million in investment portfolio would be sufficient.
And if we assume 12% dividend yield, then half a million dollars would suffice.
But where do you find stable and reliable stocks with that kind of dividend yield?
Be very cautious with very high dividend yield stocks, as you might get suckered into a dividend
trap.
A dividend trap occurs when investors are lured in by a high dividend yield, only to
find the underlying company was not such a great buy after all.
Maybe you are better off with our base case assumptions of 4% dividend yield, and using
the power of reinvesting and compounding to build the value of your investment portfolio.
Reinvesting dividends can turn your $10,000 into nearly $15,000 in 10 years, if the 4%
dividend yield continues to be achieved.
Dividend reinvesting taps into the power of exponential growth: the dividend snowball!
What if individual stock picking for dividend investing sounds like way too much work and
way too much risk?
Here’s example number two of dividend investing, using ETFs, Exchange Traded Funds.
ETFs provide scale and diversification, which is much harder to achieve for individual investors
doing stock picking.
When researching dividend investing ETFs, you might come across the S&P500 dividend
aristocrats.
These are companies that are a member of the S&P500 index, a stock market index tracking
the performance of 500 large companies listed on stock exchanges in the United States.
They are also companies that have increased dividends every year for at least 25 consecutive
years.
The underlying assumption here is that if a company has been paying and increasing dividends
for that long, they are highly likely to be paying dividends going forward.
That’s not an absolute certainty, but a significantly higher probability.
In addition, the components need to meet criteria of market capitalization and trading liquidity.
Components are added when they reach the 25 year threshold, and are removed when they:
fail to increase their dividend during a calendar year
or are removed from the S&P 500 In 2008, there were 52 companies that qualified
as an S&P500 dividend aristocrat.
In 2022, there were 64.
An increase of 12.
Sounds pretty stable, right?
Well, not really.
Below the increase of net 12, are 46 additions, and 34 removals, if I counted correctly.
Most of the removals occurred in years with severe shocks to the economy and the stock
market: 2009, 2010 and 2021.
Among the companies that were removed, are household names such as AT&T and General Electric,
which a lot of investors trusted to be paying high levels of dividend indefinitely.
A lot of fairly conservative investors got their fingers burned investing too much of
their money in just those stocks.
Dividend investing, building an investment portfolio of stocks with the main goal of
“harvesting” dividends, sounds easier than it is in reality!
If you are looking for stable income streams for the long term, you might be better off
putting part of your investment money in bonds.