We have two different ways to make money from stock investing, one is an increase in stock price due to growth in the business, known as capital appreciation and the other one is, distribution of earnings, known as dividend. In dividend investing strategy, investors buy shares of those companies that pay good and regular dividends to shareholders.
This means, in dividend investing strategy, as an investor you create a stream of income in addition to capital appreciation by buying good quality dividend paying stocks.
One of the main reasons why investors prefer dividend paying stocks is because they want to earn passive income for a better standard of living.
In this post, we have tried to answer the most common question: What is dividend investing strategy and how it helps in making passive income in the stock market.
Before getting into this article, let us first understand what is dividend.
What is dividend
Dividend is a payout issued by a corporation at regular intervals to eligible shareholders out of its earnings. In other words, it’s a distribution of profit by a corporation to its shareholders.
In general, dividends are paid by publicly traded companies when they earn profit.
Payment of dividend is decided and managed by the company’s board of directors and gets its approval from shareholders through their voting rights.
Dividends can be issued as cash payment, as shares of stock based on the dividend policy the company follows. However, it’s not mandatory for a company to pay a dividend. In general, dividend payments are subject to macroeconomic as well as company specific risk.
Some companies do not pay dividends and reinvest the entire net profit in the business itself to help sustain the higher growth and expansion. In the stock market, a good dividend investor always prefers to use his money to invest in the stocks of companies that tend to pay high dividends.
When you own stocks of a dividend paying company, you periodically based on the company’s dividend paying policy, receive a share of the profits that the company makes in proportion to your shareholding.
What are the strategy you can adopt in dividend investing
Right dividend investing strategy can help you to generate more money from following two sources;
- regular dividend income; and
- capital appreciation over time.
Your strategy might differ based on your risk taking capability. For instance, if you are a senior citizen, then your aim should be for a company with regular income with very less risk. In case of a young investor, risk taking capabilities are higher than a senior citizen, therefore, they look for companies with high return with high risk.
Prefer to invest in financially strong business
Company with less debt-to-equity ratio is a better choice as higher debt can take out the earnings in economic downturn resulting in less or no dividend, therefore, based on the type of industry, you can look for a less debt-to equity ratio company to invest in.
Debt to equity ratio of less than 50% based on the industry and sector can be considered as less risky for investment.
Find out business’s future prospects
You should also make sure that the industry in which the company operates is stable and will not have much impact in case of economic downturn. You can choose companies that have pricing power, which means in case of difficulties they can increase their product’s prices to offset inflation rate and keep making money.
For less risk, investors generally prefer buying established companies with a history of good dividends to add stability to their portfolio.
In dividend investing, investors choose companies that are mature and generate more revenues well in excess of their costs. These mature companies pay out a large part of their earnings in dividends to the shareholders instead of keeping it for reinvestment.
Dividend investing strategy is good for those investors that need a steady stream of income right away. It’s suitable for a person who is nearing or in retirement. You can reinvest your dividend amount in stocks that pay large dividends in order to make more money.
Use following key Metrics in dividend investing strategy
To evaluate a great stock for your investment purpose, here are certain metrics to understand the stock better.
Annual dividend represented as a percentage of the stock’s current price. For example if the company is paying Rs 10 as dividend and company’s current market price is Rs 100 per share, then the dividend yield would be 10%. This can be compared with industry standards or past record to know whether the market price is right from valuation prospective to invest.
Just because two companies are paying the same amount per share as dividend per year, it does not make them equitable in terms of potential investments. To compare both investment options, you need to calculate how much you will be earning from each amount invested in a company’s share. Therefore, dividend yield is one of the key parameters to tell you how much dividend you are getting for the amount invested by buying company shares.
Dividend yield is also known as dividend on investment. For example, if you get 1 rupee per share per year as dividend and your per share investment is Rs 20, then you are getting an annual dividend yield of 5%.
Dividend yield = (1/20)*100 = 5%
Now assume for a moment you are also holding shares of another company which also paid a dividend of Rs 1 per share, but you have paid Rs 40 per share to get the stock. In this case, your annual dividend yield would be 2.5% even though the per share dividend paid is 1 rupee in both cases.
Dividend yield = (1/40)*100 = 2.5%
Therefore, one of the key parameters to compare and select the best dividend paying company in the industry or sector you choose is dividend yield.
Dividend Payout Ratio
Dividends are distributed out of the company’s net profit. Therefore, it’s fair to assume that a dividend payout ratio is a good sign of a company’s financial health. Before investing, you should ask yourself what is the possibility that the company will continue paying dividends at the same or higher rate. This can be analysed by comparing earnings to dividend payments.
The dividend shown as a percentage of a company’s net profit. If you earn 10 rupees per share as dividend out of 20 rupees per share of earnings, then the payout ratio is 50%.
As a standard measure, you can make sure that the company’s dividend payout ratio is not more than 60% to 70%. This means, company is retaining 30% to 40% of its earnings for expansion out of the total net profit.
If a company is retaining a minimum of 30% to 40% of its earnings to reinvest in their own development or expansion, then it’s a long term investment opportunity for investors.
If the company’s future earning prospects are good, then chances are that the company will keep paying dividends as paid in the past.
Stocks that pay dividends are meant to be financially strong and stable from an investment point of view. A good dividend payout indicates that the management is very confident in its ability to perform well consistently to earn more profit for the company and its shareholders.
Total return will show you the stocks’s overall performance. Total return is the combination to dividends and capital gain or loss from the price change. For example, if for a year a company’s dividend yield is 5% and stock rises by 10%, then its total return is 15% for a year.
In addition to these above metrics, you can also use Earnings per share or EPS and P/E ratios to know whether a stock is fairly valued before investing.
To get eligible for dividend, you need to know various dates associated with the dividend payments schedule of the company. If you buy a stock at a wrong time, then you might lose the next dividend payouts that the company announced. To know when to get in, you should have planned your dividend capture strategy.
- Choose stocks of great companies that pay high dividends and have a stable business.
- Hold your position in a fundamentally strong business for a long period of time.
- Diversify investments across different industries and sectors by selecting good dividend paying stocks.
- Watch out dividend payout ratios of past and future estimation of earnings
- Don’t forget to calculate dividend yield before investing.
- Calculate the company’s intrinsic value to compare with market price to know how well the market has valued the stock.
- Look for financially strong stocks that pay dividends
- Forecast the business prospects of the the company and it’s earning growth
- Build a diversified portfolio of dividend paying stocks
Remember not every dividend paying stock is for long term investment. You need to learn how to identify the best ones for your portfolio in order to get the best regular income from your investment portfolio. If you are new to the stock market or not competent enough to do your own analysis, then we suggest you to take help of a financial advisor. You can also invest in the stock market through a mutual fund.