What is a dividend?

A dividend is a portion of a company’s profits that is distributed to shareholders as a way to compensate them for their investment. The most common type of dividend is a cash dividend, in which shareholders receive a lump sum for every share they hold in the company.

Companies (especially growing ones) seeking to reduce their share prices may opt to distribute stock dividends instead of a cash dividend.

[Related: For a more in-depth comparison of cash and stock dividends, see Cash vs. Stock Dividends.]

Dividends are usually paid on a quarterly basis after the company finalizes its financial reporting for the quarter. Some companies pay their dividends semi-annually, while others pay on a monthly basis.

The payment frequency, however, is of secondary importance. The greatest concern for dividend and income-oriented investors is the dividend yield.

Read Also: What are the best dividend stocks?

What is a Dividend Yield?

A dividend yield is simply a company’s annualized dividend payment divided by the company’s current share price.

Dividend Yield = Annual Dividend Per Share / Current Price Per Share

The dividend yield is one of the most important considerations for income-oriented investors because it represents the amount of cash flow they will be receiving in return for their investment. Generally, the higher the dividend yield, the higher the return on the investment.

When calculating the dividend yield, investors must take into account the fact that future dividend payouts may differ from past payouts. For example:

Last year, Company XYZ paid dividends in the following manner:

Q1: 10 cents
Q2: 20 cents
Q3: 30 cents
Q4: 40 cents

If the company were trading for $20 dollars a share, its dividend yield would be quoted as 5 percent ($1/$20). But does this paint an accurate picture of the company’s future dividend payments? After all, the future is much more pertinent to our investment decisions.

If investors believe that a company’s ability to pay dividends has changed over time, they may prefer to look at the “forward dividend yield” rather than the “trailing dividend yield” described above.

A forward dividend yield is simply a projection of what the company’s dividend yield is expected to be in the year ahead. To use the example above, if investors believe that Company XYZ’s ability to pay dividends has improved over the last year and expect the last dividend payment (40 cents) to be repeated throughout the year ahead, they may believe that the company’s “true” yield going forward is 8 percent (($.40+$.40+$.40+$.40)/$20).

Ultimately, deciding whether to use the trailing dividend yield or future dividend yield will depend on your ability to accurately project future dividends.

If you are sure that once a company increases its dividends, it will continue to pay at that rate or higher, you may want to annualize the most recent dividend payment to get a sense of what the dividend yield will be going forward.

However, if a company has large fluctuations in its dividend payments and it is difficult to predict future dividends, the trailing dividend yield will be more reliable.

How to Determine if a Company Will Increase or Decrease its Dividend in the Future?

When investing in dividend-paying stocks, investors need to be mindful of the trade-off between risk and reward. If a company suddenly can’t generate enough cash flow to support its dividend, it may cut the dividend or get rid of it altogether.

To determine the safety of a company’s dividend, investors look to the payout ratio.

What Is The Payout Ratio?

Healthy businesses generate large amounts of cash flow and earnings. For a dividend to be sustainable, the amount paid out to investors must be well covered by the amount of cash coming into the business. How well the dividend is covered by actual cash is measured by the payout ratio.

Payout Ratio = Dividends Per Share / Earnings Per Share

The lower the payout ratio, the more resistant a company’s dividend payouts will be to future declines in earnings. A company with a high payout ratio distributes a significant portion of its current profits to shareholders, while a company with a low payout ratio distributes a small portion of its profits in dividends.

If future earnings decline for a company with a low payout ratio, it’s still likely to generate enough cash flow to support dividend payments. Moreover, because companies with low payout ratios pay out only a small percentage of their profits, they are more likely to have room to increase future dividends than companies with high payout ratios.

[Related: Investing Daily analyst Jim Fink takes an in-depth look at using the payout ratio to find investment bargains in Sustainable Dividends Depend on the Payout Ratio.]

Why Invest in Dividend-Paying Companies?

Studies consistently show that dividend-paying stocks as a group outperform non-dividend paying stocks. For example, Al Frank Asset Management performed a study of large-capitalization stocks between 1990 and 2005 and found that dividend payers not only returned more, but did so with less volatility. Dividend-paying stocks exhibit superior investment qualities for many reasons:

1. Dividend-paying stocks provide income. With investments that don’t pay dividends, investors only realize profits when they sell. Dividend-paying stocks pay out cash in regular installments that can be reinvested, saved, or spent.
2. Dividend-paying stocks have higher earnings growth. According to the findings of research group Research Affiliates, many companies that don’t pay dividends misallocate capital towards projects that don’t benefit shareholders. Requiring company executives to pay out cash dividends to shareholders imposes discipline on their management decisions and compels them to only invest in the highest-return projects.
3. Dividend-paying stocks have higher earnings quality. According to a research paper by Douglas J. Skinner and Eugene F. Soltes, companies only pay dividends if they believe that they are financially healthy enough. This results in a “natural selection” whereby only companies with strong and stable earnings streams decide to pay dividends.
4. Dividend-paying stocks are easier to value. Because it is much easier to value a company based on future dividend payments than on predicted future earnings, dividend-paying stocks tend to be less volatile than non-dividend paying companies.

Which Dividend-Paying Stocks Are Best?

Dividend yields can vary greatly from company to company, based on the market’s perception of the company’s riskiness and growth prospects.

Dividend-paying companies can be categorized into three groups:

• Low dividend yield. These companies feature dividend yields less than 2 percent and are more focused on growing operations than providing income to shareholders.
• Medium dividend yield. Medium dividend-yield companies feature dividend yields between 2 percent and 4 percent. Typically, these are stable companies with safe dividend payouts and some growth opportunities.
• High dividend yield. These companies pay dividends that yield 4+ percent and are favored by investors looking to generate income from their investments. Stocks with dividend yields greater than 10 percent are perceived by the market to be very risky, suggesting that a dividend cut may be forthcoming.

Readers should note that the current classifications are based on a low-yield macroeconomic environment. If US Treasury yields begin to rise, corporate dividend yields will most likely rise as well.

Read Also: What’re the best dividend stocks?

Good Places to Find Solid Dividend-Paying Stocks

Today, the very safest dividend-paying stocks–regulated electric, gas and water utilities–yield 3 percent to 5 percent. Master limited partnerships (MLP) that own pipelines are virtually as secure as utilities, and they offer yields as high as 7 percent to 8 percent, thanks to their tax-advantaged status. Finally, many US telephone stocks are yielding well over 8 percent, reflecting their out-of-favor status.

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