Investing in the stock market has always sometimes considered an expensive activity that could only be done profitably by very few people.
Part of this belief stems from the fact that there are an unimaginable number of trading instruments of all kinds in the stock market, which automatically begs the question, “How should I invest? Where should I start?”.
Where to Start with Dividend Paying Stocks
Throughout my career in the financial markets, I have asked myself some of the same questions that you may have now, but, after more than three years of study and research, I have found my groove in the markets and am beginning to build a significant stock portfolio. One of the main investments in my portfolio are both dividend stocks and growth stocks.
So in this article, I will also share my experience in calculating the expected return of dividend growth stocks using a real life example.
Is it Too Late to Get Started with Dividend Investing?
Nowadays, you often read on the internet that “the 20s are for grinding”, “you need the compound interest effect of the 20s to invest” and so on. Even though it is true that the earlier you start, the better results you will get, it is NEVER too late to build a stock portfolio and start earning passive income with high dividend stocks.
How to Generate Income Now
In this article, we will simplify the concept of investing, explaining everything that you need to know and answering these questions for you, focusing mainly on dividend investing and dividend growth stocks. Then we are going to compare the two most popular (and successful) investing strategies and, finally, I am going to show you the practical example of the returns of a dividend growth stock
What Are Dividends And Why Are They Paid?
Dividends are a portion of a company’s profits distributed to shareholders. They are considered a reward for the investors who believed in the company and bought its shares.
Not every company pays dividends, and every company is free to decide almost every aspect of dividend payment. This is because the availability of profits to share with investors depends on many factors such as the industry and market positioning of the company. Ultimately, they are trying to decide what to do with the cash flow of the company…. pay investors or invest back into the company.
Typically, only established companies that have exploited almost all of their potential and therefore do not need all of their profits for business investments can pay high dividends.
Most of these companies operate in sectors such as utilities, oil and gas, and basic materials, where profits are nearly constant, new competitors are unlikely to enter the market, and each company has already expanded as far as it can. They are usually “cash cow” businesses.
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On the other hand, one sector where only a handful of companies can pay dividends is the technology sector. This is because this industry is constantly evolving and companies have to invest billions of dollars in research and development just to maintain their market position.
How Are Dividends Paid?
Who Makes the Decision on Dividend Payouts?
The firm’s decisions about dividends depend solely on the board of directors, which is the governing body elected by the shareholders to oversee management and decide business strategies. The board of directors is in charge of deciding the method by which dividends will be paid, the frequency of the payments, and the amount.
Cash Dividend vs Stock Dividend
There are two methods by which the dividends can be paid: with cash or with additional shares. When a company pays dividends in cash, you simply receive the payment in your bank account a couple of days after the dividends are paid by the company. If instead the dividends are paid with additional shares, you simply receive the new stocks in your investment portfolio.
Each of the two methods has both pros and cons, for example, when you receive dividend payments in cash, the amount that you receive was previously taxed by the firm as “corporate tax”, and now, it has to be taxed again as “long term capital gains”.
On the other hand, when dividends are paid in shares you simply receive the new capital in your investment portfolio ready to be invested again, but you do not have the extra liquidity (cash flow!) in the bank that you would have had otherwise.
What Is the Amount Of Dividends Paid?
The Dividend Yield
The amount of dividends paid is often expressed as a percentage and is called the “dividend yield“. It is calculated by dividing the dividend amount per share by the price of the share and then multiplying the result by 100.
This dividend yield in percentage form makes it very easy for an investor to determine the dividend payment they will receive, because by dividing the dividend yield percentage by 100 and then multiplying it by the amount invested in the company, you get your pre-tax dividend payment.
They Payout Ratio
Additionally, another key indicator of the amount redistributed to the investors by the dividend stocks is the payout ratio, which is calculated the total amount of dividends divided by the net income of the company. This ratio is crucial to determine whether the dividend yield is adequate or not to the company’s earnings growth rate, as an excessive dividend yield could be very dangerous for the company in the long run.
When Are Dividends Paid?
The Board of Directors is also responsible for deciding on the frequency of dividend payments.
Generally, most companies pay their dividends either quarterly or semi-annually, but other companies pay them every month, and the frequency of payments usually depends on the type of sector in which the company operates.
For example, if a company operates in a sector that is very susceptible to seasonal fluctuations and where sales drop significantly in the summer and boom in the winter, it might decide to pay the dividend less frequently to avoid consuming a large portion of profits in the summer or having a very low dividend.
On the other hand, a company with constant profits throughout the year might even decide to pay a dividend every month to offer investors the luxury of constant dividend payments.
In addition, it is important to note that in order to receive the dividend payment, the investor must purchase the company’s stock no later than the last business day prior to the “ex-dividend date,” which is the date on which the dividend entitlement expires.
The dividend payment itself can then take more than a month, because after the ex-dividend date, usually two business days later, comes the “date of record” when the company registers all shareholders entitled to the dividend payment, and finally the payment is not made for several weeks.
What Are Special Dividend Payments?
In addition to recurring dividend payments, a company may also decide to make special or non-recurring dividend payments, either together with the scheduled payment or individually. These special dividends are simply a “bonus” given to investors in addition to their normal dividend payment.
These payments may be announced when there is good news for the company, such as a particularly productive period for the company or an easing of future market conditions.
Growth Investing vs Dividend Investing
When we think about stock investment strategies, we always think of these two alternatives: growth investing and dividend investing.
Growth investing consists of buying stocks of companies that have solid fundamentals and operate in a high-growth sector. The idea behind this strategy is to find the companies that are projected to have above-average earnings growth and then hold the shares until the company reaches its full potential.
Originally, this investment strategy was limited to small to mid-sized companies, as it was assumed that larger companies were already established and had reached their full potential. More recently, however, larger companies have been included in the growth stock category, operating in fast-growing sectors such as technology. This is due to technological innovation, which has prompted even established companies to expand their product range.
Dividend investing, on the other hand, is an investment strategy based on buying shares of a dividend-paying company. Generally, these companies are well-established firms in stable markets where market share is static and innovation is limited. Because of these market characteristics, the companies do not have to reinvest as much and can therefore share some of their profits.
Pros and Cons Of Each Strategy
Growth Investing and Dividend Investing are basically the two polar opposites in building a portfolio, so each strategy has its advantages and disadvantages.
The advantages of growth investing clearly include the returns generated by this strategy. On average, this strategy yields higher returns than a dividend portfolio because the growth of these companies is almost exponential once they become profitable.
However, there are also some disadvantages of growth investing. First of all, it is a less “passive” way of investing than dividend investing, since a significant amount of research has to be done up front and then you should keep an eye on every component of the portfolio to make sure that none of the companies become unprofitable.
In addition, portfolios consisting entirely of growth stocks do not tend to grow linearly, but rather follow the business cycle fairly closely. Therefore, expected returns can be significantly affected by seasonality.
A final disadvantage of growth investing and holding stocks in general is that the returns are just “unrealized gains” until you sell the stocks. So even if your strategy has generated substantial returns, you may not benefit immediately.
Dividend investing, on the other hand, is a much more “passive” way to earn income, as dividend-paying companies are often more stable and established. However, dividends have one very clear disadvantage: taxation.
Dividends are “double taxed” because they are the net profits of the company distributed to its shareholders. So first the company has to pay corporate income tax on its earnings and then the investor has to pay their income tax on the dividend distribution.
Another disadvantage of dividend investing is that the shares of a dividend company are usually more stable in value than the shares of a growth company, so the main source of income for investors is the dividend payout, leaving little room for price appreciation.
What Are Dividend Growth Stocks
Dividend growth stocks are a special subset of dividend stocks, consisting of any company that not only has a high dividend yield, but also has significant growth to increase its dividend payout over time.
In general, dividend growth stocks can be considered the balanced middle ground between growth stocks and traditional dividend stocks, as they have sufficient growth potential to grow earnings while paying out a high dividend yield.
Therefore, investors holding a portfolio of dividend growth stocks can benefit from both dividend payments and share price appreciation over time.
What Are Dividend Aristocrats?
Dividend aristocrats are considered the “top of the top” of dividend stocks. To be a Dividend Aristocrat, a company must be in the S&P500 index and have consistently paid and increased dividends over the past 25+ years.
In general, these companies not only represent a safer investment as they are usually large and well positioned in the market, but most of them also have an average dividend yield at least double that of the S&P500.
Thanks to these companies, it is possible to build a dividend portfolio that generates double-digit returns, with the likelihood that the dividend will increase every year.
Case Study: Analysis of Leggett & Platt’s 2022 Returns
There are many parameters to consider when selecting a growth dividend stock for this analysis, including the sector in which the company operates, the consistency of earnings, the dividend payout ratio, the overall economic conditions and more.
For this analysis, I chose Leggett & Platt (ticker: LEG), one of the dividend aristocrats with the highest dividend yield. LEG operates in the innovative design and manufacturing industry and has generated positive net income and substantial earnings per share of about $2.5 per share over the past 7 years.
Returns From Price Appreciation
As we unfortunately know, 2022 was not a good year for investing in the stock market due to inflation concerns, interest rate hikes and geopolitical tensions. For this reason, the price of the US S&P500 index fell by 20.17% between the first and the last trading day of 2022.
Similarly, LEG has also succumbed to a similar destiny. Since LEG is an innovative company, like most growth stocks, it pretty much follows the market, which means higher returns in bull markets but lower returns in bear markets compared to other less volatile dividend stocks. Therefore, the share price of LEG fell by 21.77% during the same trading period.
However, it is important to note that throughout the same period, despite the unfavorable market conditions, some Dividend Aristocrats lost significantly less value than the market, while others even saw their price increase.
This is the case, for example, with Exxon Mobil (ticker: XOM), whose share price soared by over 90% in 2022, even though this was mainly due to the price shock in petroleum products rather than the company’s capabilities.
Returns From Price Appreciation
Despite a sharper decline than the market, LEG still outperformed the market in 2022 thanks to its dividend payments.
LEG pays its dividends quarterly and in 2022 had one dividend payment of $0.42 per share and three payments of $0.44 per share, for a total of $1.74 per share. Considering that the price per share of LEG was $32.23 at the end of 2022, we can calculate that the company’s dividend yield generated an additional 5.4% return, which is calculated by dividing the total dividend payment bdy the share price.
Then, we can see that the total annual return of LEG in 2022 is -16.37%, which is calculated as the sum of the capital appreciation and the total annual dividend yield.
Despite the fact that this is still a rather high negative return, we must acknowledge that it was caused by abnormal market conditions and that it is still better than the market index’s performance, whose price has fallen by 20.17% and does not pay dividends.
How To Get Started Investing In Dividend Growth Stocks?
All in all, we have seen that when we break down the tedious task of stock investing into small components, it is actually a very simple idea as it boils down to the small elements like dividend yield, payout ratio, earnings growth rate and little else.
Of course, everyone should do their own research before diving into the investment world, but from my personal experience, I know that nothing is more instructive than real life examples and practical case studies.
Three Activities to Get Started in Dividend Investing
So if you are really interested in dividend investing, I can recommend three main activities.
First, search for the Dividend Aristocrats list, pick a random company, and then do the same analysis I did for LEG. This will teach you how to search for stock prices and information, and how to navigate the Internet with financial content.
Second, you should research the technical and fundamental information of the company you selected earlier, including earnings per share, dividend yield, beta, market capitalization and more. If you do not know the significance of any of this information, you should carry out a quick research on the internet and write down the meaning, as it will help you immensely in understanding stocks.
Finally, what helped me the most before my professional career even began was opening a paper account. This step is extremely useful because it projects you directly into the world of the stock market without any risk. With a paper account, you can familiarize yourself with how to open and close a position, how to look at charts, and understand the broker’s fee structure.
Do Dividend Stocks Grow In Price?
It depends on the type of dividend stock. Generally, shares of established companies that operate in static markets do not have price fluctuations. However, if you consider dividend growth stocks instead, then these stocks tend to follow the market more closely, so you can expect an average return similar to that of the market.
An extremely useful metric you can use to quickly estimate a stock’s average return is beta. Beta represents the average change in the stock price divided by the average change in the market index. If the beta is close to zero, the stock’s price is more stable and does not follow the market. On the other hand, if it is 1, you can expect similar returns to the market.
Which Dividend Growth Stocks Are Best To Buy In 2023?
The best dividend stocks are those that have a history of reliability and profitability. The easiest way to find the best dividend growth stocks is to look at the Dividend Aristocrats list.
From there, you can filter out each dividend stock based on additional criteria such as dividend payment frequency, dividend yield, payout ratio and more.
The “best” in the stock market always depends on the circumstances. So the optimal strategy is always to differentiate as much as possible to minimize the risk of individual companies in your portfolio.
Are Dividend Growth Stocks ETFs Profitable?
Dividend ETFs are definitely a viable option for investors who do not want to build their portfolio from scratch. In general, dividend ETFs generate lower returns than the average dividend portfolio, but they also carry less risk because they are composed by a more varied stock selection.
How Much Money Is Needed To Entirely Live On Dividends?
The quick answer is that it depends on your lifestyle. For example, if your lifestyle requires a gross income of $3,000 per month, you should build a dividend portfolio that earns at least $36,000 per year.
If we assume that the portfolio generates a dividend yield of 10% per year, then you need to invest $360,000 in the portfolio.