What is a “Dividend Stock”?
Dividend stocks are shares of companies that distribute their profits to existing shareholders in the form of dividends. Opposite to growth stocks, which tend to reinvest profits in order to generate higher growth rates, dividend stocks distribute regular payments to investors which should be supportive for the total return (income plus capital growth) profile of the company. This tends to be the preferred route of well-established and more mature companies as usually they are in the late cycle of their development and growth opportunities are limited.
Key Learning Points
- A dividend is the distribution of company profits to existing shareholders paid out in the form of cash per share, or in some cases company shares
- Dividend stocks tend to be more mature and well-established companies that have relatively smaller scope for growth – most of them already occupy reasonable market share in their segment or are in well-developed industries
- Individual dividend payments may initially look modest, but over the long-term they have considerable role in generating total return from an investment
- Investing for dividends could be a good opportunity for investors that seek some passive income
Investing for Income
One of the key advantages that dividend-paying stocks offer to investors is the potential to create a passive income stream. In terms of geography, the UK market has a strong heritage and culture of paying dividends and is a typical hunting ground for income investors. There are also various other regions that offer decent yields and diversification of income such as Europe, the US or Emerging Markets. As well as geography, dividend-play opportunities are often concentrated on the more developed sectors in the market rather than technology and newer industries.
Another way of utilizing dividend payments is to reinvest them and use the power of compounding to generate a higher total return over the long-term. That is the process of generating return on previous reinvested dividends and potentially earning more income in the future.
Understanding Dividend Yield
The dividend yield is a key financial ratio that calculates the dividends paid out relative to the company’s share price expressed as a percentage. Many investors use dividend yield figures as guidance for potential income return on their investment, but however, that would be a tricky assumption. As yield is influenced by share price, any decline could make the dividend yield look higher if the payouts remain at the same level. These stocks may represent perhaps a short-term dividend opportunity but may have longer-term issues. In addition, although a high dividend yield may look an attractive income opportunity, that could be also an indicator of lower growth potential.
Dividend Yield Formula:
Dividend Yield = Dividend Per Share / Price Per Share
How to use Dividend Stocks in a Portfolio
As dividend paying companies tend to be more well-established, quality companies, regions and sectors, they also tend to provide some capital protection opportunities during periods of market stress. They typically have a lower volatility profile than the broader market. Generally, the majority of income-paying stocks tend to be positioned in mature sectors such as utilities, real estate, energy or financial services. Typical growth areas such as technology offer very limited dividend opportunities as cash in usually reinvested back into the business to fund growth.
Dividend stocks are usually a good fit for more a conservative investor, who has lower risk tolerance and is seeking a consistent source of income (which keeps up with inflation). Subject to an individual’s personal circumstances and objectives, dividend stocks could form either a core part of a well-diversified portfolio, or be used as a satellite income engine to a more diversified portfolio.