Most investors can never forget the first time a stock they owned paid them a dividend. Absolutely nothing makes an investor feel more like a part-owner of a business than cash paid out directly from profits.
If you’re an income-seeking investor, there’s a good chance a substantial portion of your portfolio is made up of dividend-paying stocks. Here are five facts you probably didn’t know about these regular payments:
- You can use dividends to value stocks
Professional stock pickers and equity analysts live by a simple rule – any security is worth the present value of its future cash flows.
Most investors rely on some crude measure of profits, earnings, or free cash flow to measure the value of the company before investing in it. With companies that pay a high dividend, it makes sense to treat the cash flow as the basis for valuation. A whole branch of stock valuation is dedicated to dividends. It is known as the Dividend Discount Model or DDM.
- Some companies pay more dividends than they can afford
Another lesser known fact about dividends is that some companies pay out more in dividends than they can afford. The payout ratio is, essentially, the ratio of dividend payment to earnings per year. Most companies payout a portion of their annual earnings as dividends. Some, however, borrow money or pay investors from their cash hoard. Borrowing to pay dividends is a risky strategy and investors are advised to run a health-check on their dividend stocks to see if the rate they’re paying now is sustainable over the long term.
- Dividends have contributed nearly half of all stock market returns
This is probably the most surprising fact of them all. Researchers calculated returns on the S&P 500 since 1940 and discovered that dividends contributed over 60% of the total return over that period. In other words, most of the money made on the stock market has come from dividends and compounding over time.
- There are dividend-focused ETFs
You don’t need to weed out individual dividend stocks to create an income portfolio. There’s a lot of different ways to get exposure to dividend paying stocks and the best way could be to buy a dividend ETF. Exchange Traded Funds or ETFs are basically a basket of stocks that trade like a normal security on the stock exchange. You can buy a basket of great dividend stocks and hold them for some amazing returns over time.
- The yield on stocks is declining
A FactSet research report seems to suggest that the rate of dividends is gradually declining. Currently, the dividend yield on the S&P 500 is close to 2.2%. However, in the 1960’s and 70’s, the dividend yield on the market rarely fell below 3%. Part of the problem seems to be historically low interest rates and historically high stock prices. The lower yield on fixed income assets has pushed stock prices higher, which has depressed the dividend yield. There’s simply no way to know how long this situation will last.
These five facts could tell you a lot about those juicy dividend payments you receive on your holdings. Dividends are an intriguing subject for any investor, but they’re particularly interesting if you want to understand the market and generate a substantial income from your investments.