What is a Dividend?
Investing can be complicated. Through this website, the T.A. and I have tried to simplify it into terms that the average teacher can understand. The focus of this post will be on dividends.
So far, we have talked about saving your money and investing it into primarily index funds to make things as simple as possible. Now that you are starting to get a better understanding of what stocks and index funds can do, I want to explain the importance of dividends in your portfolio.
In it's simplest terms, a dividend is in the interest that a company pays you for you "borrowing" them your money. By purchasing a company's stock, you are "loaning" them your money. They use that money to improve their business and grow profits. If you have purchased stock in a good company, they will have a profit each quarter, and they may pay their stockholders a percentage of those profits. A key point is that NOT ALL COMPANIES pay dividends. This does NOT mean those are bad companies. Maybe it's a company that is still growing and is investing their profits into growing and are not yet ready to pay out dividends. The stock price is climbing because their company is growing and your money is still growing. Index funds, ETFs, and mutual funds may also pay dividends out to their shareholders.
Dividends can be paid at different times during the year. Some companies will distribute a yearly dividend at the end of their fiscal year. Others will distribute them semi-annually, quarterly, or even monthly. There really is no set rule as to when companies will distribute them. Some companies will even announce a "special" dividend if they have an extra profitable fiscal quarter or year.
Dividends are measured in their annual yield. This yield is figured by dividing the total yearly dividend paid by their stock divided by the stock's price. Let's take a common ETF that we have discussed in previous posts, Vanguard Total Stock Market Index Fund (VTI).
VTI's share price as of this post is $155.83. The dividend paid over the last 12 months is $2.74. If you divide $2.74 by $155.83, you get 0.176. Multiply by 100 and you get 1.76%. So currently, VTI has a yield of 1.76%. It's really not that difficult to calculate.
So the quick decision people make is, oh, just find the stocks with the best yield and buy all of them! Not so fast... You need to make sure that the dividend for that stock is sustainable. Maybe their share price has plummeted due to a poor quarterly report. Their yield will jump, but they may have to cut their dividend because they didn't make enough money to pay the previous dividend amount. It is important to keep an eye on a company's earnings per share (EPS) each quarter. If a company only profited $1.32/share for the previous year, paying $1.40/share dividend isn't going to be sustainable.
So how can we use dividends to grow our wealth?
A popular way of dividend investing is to invest in strong companies that have a history of raising their dividends over time. This is a great way of increasing your yield. It is commonly referred to as Dividend Growth Investing or DGI. Let's take a look at an example of how your yield can grow over time.
You decide to buy Company A. They are a solid energy company that has continually raised their dividends over the last 10 years. You decide to purchase 100 shares at $100/share. At the time of your purchase, the company had a yield of 1.5%, so for your $10,000 investment, you were paid $150/year in dividends.
Fast forward 10 years. You've held those 100 shares in Company A over the last 10 years. Each year, you have received your dividend. Also, the stock price has steadily climbed and is now $140/share. During this time, the dividend continued to increase each year as well. Now they have an annual yield of 1.75%, so based off of that $140 share price, the yearly dividend in now $2.45/share. So if we look at your original purchase of $100/share, your yield on cost (YOC) is now 2.45%! This is how dividend growth works. It's not unheard of for people that have held their stocks for 20-30 years to be receiving 10% yields or more on that money they originally invested.
The negative of dividends is that if they are in your taxable accounts, you will have to pay taxes on them depending on your tax bracket. If you have held the stock for under a year, any dividends you receive will be "unqualified" and you will have to treat them like income and pay taxes on them according to your tax rate. If you have held them for longer than a year, they are considered "qualified" dividends and are subject to a different tax rate that will depend on your income level.
This is why many people hold their dividend stocks in their tax-sheltered accounts like your 403b, IRA, or Roth.
While index funds are still our #1 recommendation for investing dividends can be a great way to provide yourself passive income and add some diversity to your account.Your money making money for you, and that will help you to.....
KEEP STACKIN!
