A dividend is a payment given to the company's shareholders on a regular basis. Generally speaking, this term means: ‘an additional outcome’ and it can also be used outside of finance and investing. If a farmer buys a cow, the milk it produces can be called a dividend and a growth in the cow's weight can be called a capital gain, which at some point can be “cashed out”.
Receiving dividends was the main goal of all of the early companies.
The British East India Company, which was one of the first public companies, offered an option to finance long trips to colonial India and if those trips were successful (this was a risky journey), investors would get a portion of the company's trade income. This concept has evolved quite a bit since then and, nowadays, many companies don't pay any dividends at all.
The core idea of dividends still remains the same as it used to be, dividends are paid from a company's net profit and they are usually based on it. If a company makes a good income, it usually pays out some of this money to its shareholders although many companies may try to hide the fact that they are profitable in order to minimize their taxes.
Not all stocks are created the same and different stock classes can give or take different benefits for the shareholders. Some stocks may not pay any dividends and some stocks can deny its owners the right to vote on a companies’ affairs.
How to Benefit From Dividends?
When an investor buys a stock, he has two ways to make a profit:
- Capital gains
The majority of investors are purchasing stocks for capital gain purposes. In other words, they want to gain income from the increase of a stock price. There are two main problems with this strategy: price might not go up and you also have to sell the stock you're holding in order to take your profit.
With dividends, it's possible to have a completely different strategy (usually a long-term strategy) with which you don't have to care that much about the current stock price and you don't have to sell anything but you'll still get a regular income based on the number of stocks you own and how much dividend do they pay. By holding a stock that has a positive dividend history, you can get regular payments from that company and this will be a nice way to make money. Although these payments are usually not very big, they tend to be pretty stable.
Example of a Dividend
Let's take Johnson & Johnson (JNJ) company as an example.
At some point in the past, their dividend yield was at 2.74%, which was one of the highest on the market.
The dividend yield is how the profitability of a stock's dividends is measured and it's equal to an annual dividend divided by a current market price of a share.
So, if JNJ price is $140 at the moment and the div yield is 2.75%, then we can calculate the annual dividend payments which is equal to $3.85 per share. What does this number mean?
If you think about it, 2.75% of annual returns is quite a high number. Many people have their savings in banks who give them about 1-2% annual interest on their capital but JNJ can give you much more than that (with almost 100% guarantee), plus some capital gains (if those will occur). Even if stock price would go down for a moment, with such a dividend yield you can wait for a long time and keep your stocks unsold, still making money out of it.
To learn more about dividend yield you can check out this article.
What Stocks to Buy For The Best Dividend Income?
Actually, there is a lot of companies paying good dividends these days and you can find yields as high as 5-6% quite easily, but the real question is: how reliable those companies are?
Surely, a new company on the market can promise great dividends at the beginning, but who knows if they keep the same ratio for a long time? No company can guarantee a certain future dividend yield because it depends on the current company state as well as many other factors that are not yet known so all of the future dividends might change and there is no way to know for sure if the current yield will stay the same in the future.
The key here is to look at how reliable a company is and what is its track record of dividend payments.
If a company kept a good dividend rate for a long period of time, (3-5+ years), that's a good sign. In the case of a company with no history you might get your first nice dividends income, but what if the next year they would decide to cancel dividends and their stocks would fall sharply? That's the thing you have to look at: a company's history.
Many investors are focused on the technical analysis, current trends and news. Some people will look at the annual reports and fundamental analysis too, but it is rather uncommon. The situation might change any minute and if you rely on capital gains, you have to watch current stock prices constantly.
With the dividend gains strategy, you would need a different approach to analysis.
It requires a deep look into the company's history and understanding of the way a company makes its money, therefore if you'd like to avoid classic market hysteria and play it smart - you can move toward a dividend income strategy.