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The Top 5 Things You Need to Know About Dividend Paying Stocks

 

The following is a post by Kanwal Sarai, the founder of Simply Investing.

Dividends are cash payments made to shareholders.  As a shareholder you are part owner of the company and therefore are entitled to share in the profits. Dividends can also help you determine when a share is undervalued, and priced right for purchase.

There are a number of other additional benefits to owning dividend paying shares, and I discuss my top five in this article.

1.       Dividends provide an immediate return

Dividends provide an immediate return on your investment. Suppose you buy shares in company XYZ, where the dividend is $1 per share per year, and the share price is $20. $1 dividend divided by $20 gives you a 5% return. This means that if you bought $2000 worth of shares in company XYZ you would receive $100 in dividends (in cash) every year for as long as you own those shares, and as long as the company continues to pay the dividend.  The dividend is paid regardless of the share price.  The share price could go up or go down (in fact share prices fluctuate every day) but you will continue to earn 5% each year on your initial investment of $2000.  The dividends are yours to keep, you can choose to spend the money or reinvest it into buying more shares. Without dividends you solely rely on share price appreciation, the gains are only made if you sell the stock for a profit, without dividends there is no immediate return on your investment.

2.       Your safety buffer against the worst case scenario

Dividends provide a safety buffer against share price fluctuations or even the worst case scenario, where the company goes bankrupt and the shares become worthless. Remember once dividends are paid to you, they cannot be recalled or taken back; the dividends (money) are yours to keep. So even if a company goes bankrupt, the dividends you have received to date provide you with some cushion to help minimize your losses.  If you owned shares in a company that did not pay dividends, and the company went bankrupt you would lose 100% of your money.

In a personal example I purchased $2479 worth of TRP (TransCanada) shares in 2000. Since then I have received $2475.26 in dividends, which almost equals my initial investment. By next year I expect to have earned over $2479 in dividends. TRP shares trade at around $43 today, but even if the share price dropped to $35 or $20, I’d still be making money because the dividends have provided me with a margin of safety against any losses.

3.       Dividends increase over time

Over time financially healthy companies increase their dividend. But why is this important to you? It is important because it means more money for you!  Let’s take a look at a real-life example and see what happens to your return as the dividends are increased over time:

McDonald’s (MCD)

Year       -              Dividend

2003       -              $0.40

2004       -              $0.55

2005       -              $0.67

2006       -              $1.00

2007       -              $1.50

2008       -              $1.63

2009       -              $2.05

2010       -              $2.26

2011       -              $2.53

2012       -              $2.80

Suppose you purchased 150 shares of McDonald’s in 2003 for $13.34 each:  150 shares*$13.34 = $2001 initial investment.

Yield on Cost = Current Dividend / Stock Purchase Price:  Yield on Cost = $2.80 / $13.34

Yield on Cost = 21%.

After ten years you would have earned 21% based on your original investment of $2001. In ten years your return on $2001 has gone from 3% to 21%, and all you had to do was hold on to those shares. McDonald’s has increased their dividend every year since 1976!

Here’s a list of some other companies and the number of years of consecutive dividend increase:

Abbott Labs (ABT), 37 years

Coca-Cola (KO), 48 years

Johnson & Johnson (JNJ), 48 years

Proctor & Gamble (PG), 56 years

(Disclaimer:  My Own Advisor owns all four of these companies).

That’s consecutive years of dividend increases, dividends increased every single year during the following disasterous events:  9/11, the Iraq war, the credit crunch, the bailouts, high unemployment, the Euro crisis….and so on.  Now I can’t predict the future, but I have a high degree of confidence that companies like MCD, ABT, KO, JNJ, and PG will increase their dividends next year or at the very least maintain their current dividend.

4.       Dividends have a long history of being paid

Some people will argue that dividends are not guaranteed, and that companies are under no legal obligation to pay dividends.  That’s true.  However, quality, financially healthy companies not only increase their dividends over time but they also have a long history of paying dividends.  Companies know that a dividend decrease will result in a decrease in the share price, which is exactly what they don’t want.  So quality companies will crunch the numbers, and verify the numbers to ensure that they can continue to pay dividends, and continue to increase dividends over time.   A dividend increase is a positive sign that the company believes that they have the financial resources to continue to pay dividends.

Here’s a list of some Canadian companies that have been paying dividends for a very long time:

Bank of Montreal, since 1829

Bank of Nova Scotia, since 1833

Toronto-Dominion Bank, since 1857

Royal Bank of Canada, since 1870

BCE Inc., since 1881

Fortis, since 1949

Enbridge, since 1952

(Disclaimer: My Own Advisor owns most of the companies above).

5.       Dividend yield can help you determine when to buy

You may have heard of the term “buy low, sell high” but how do you know when to buy low, how do you determine when a stock is undervalued? Using dividend yield you can determine if a stock is undervalued or overvalued. Let’s take a look….

I’ll continue with our example of company XYZ, where the dividend is $1, and the share price is $20. Now suppose that the stock price drops to $15 or $8.  What happens to the dividend yield?

Dividend / Share Price = Dividend Yield

$1 / $20 = 5%

$1 / $15 = 6.7%

$1 / $8 = 12.5%

Notice as the share price decreases the dividend yield goes up. All things considered equal is it better to buy the shares at $20 or $15 or $8?  In this example, $8 would be the best price to pay for the shares because you would be earning 12.5% on your investment!  Remember as the share price goes down the dividend yield goes up, and as the share price goes up the dividend yield goes down. You want to buy shares when the stock price is historically low.

Suppose the average dividend yield for company XYZ is 4.5%, the shares are then undervalued when the current dividend yield is higher than the average dividend yield.  If the current yield is 9% you can be sure that the shares in company XYZ are undervalued and worth considering.   If the current dividend yield is 2%, the shares are overvalued.  This example demonstrates it is important to consider the average dividend yield for a particular stock before purchase.

There are other factors to consider before making a stock purchase decision, but checking the current yield against the average dividend yield should be the first factor to consider; actually it’s very important to me.  Since I started the value investing approach I have never purchased a stock when its current yield was lower than its average yield. This first step alone has saved me thousands in losses, and has provided me with thousands in gains. You can do the same with your investments if you remember to buy quality dividend paying companies when they are undervalued.

Happy Investing!

Kanwal Sarai, is the founder of Simply Investing, and on a quest to bring financial freedom to all. He created the Simply Investing Online Course on the belief that the world can be a better place if people didn’t have to worry or stress out about money. Simply Investing’s goal is to make investing easy, save you time, and help you safely earn more.

Thanks to Kanwal for this post and his on-going support of My Own Advisor.

Filed in: Uncategorized

16 Responses to "The Top 5 Things You Need to Know About Dividend Paying Stocks"

  1. unbalanced says:

    How do you know what a companies average dividend is ? Do you also consider P / E ratio ? Thanks in advance. Just trying to learn.

  2. Doug says:

    Question:how do you know what a company’s average DVD is?

  3. You don’t know the average dividend yield for the future, but you can compute it for the past. Assuming the dividends are consistent rather than one-time, you can go to Google finance or whatever and look up the old dividends on the chart. At each point where a dividend is payed, you can calculate the instantaneous yield via this formula:

    yield = amount paid * (dividends per year) / stock price

    Then average those yields back a way, and you’ll know the average dividend.

  4. unbalanced says:

    To Offroad Finance, thankyou for your explanation on the following question I posted.

  5. @unbalanced Yes, I do also take the P/E ratio into consideration. Typically I will compare the P/E ratio of companies within the same industry. For example if the oil companies are trading at around a P/E of 12 and the company I am thinking of buying is at a P/E ratio of 25 I would consider that too high. Ideally in this example I’d want to look for a company with a P/E of around 12 or lower.

    In addition to the P/E ratio and average dividend there are a number of other things to consider before making a buy decision:

    - is the company consistently profitable? (has the EPS increased year after year)
    - how much debt is the company carrying?
    - does the company have a history of increasing dividends

  6. There are 3 options to obtain the average dividend yield:

    1. For US stocks you can use Value Line even though a subscription is required, they do provide free reports on the 30 companies that make up the Dow:

    Download the PDF for say Johnson & Johnson. In the table, look at the 10th row down “Avg Ann’l Div’d Yield”. So in this case I would take the average of the last 16 years.

    Most public libraries carry a subscription to Value Line.

    2. Yahoo Finance provides the “5 Year Average Dividend Yield” for some stocks.

    3. The fourth option is to calculate the average dividend yield yourself:

    Take the high and low stock prices for the year then divide it by two. Then take the dividend and divide it by the average price for that year. After you get the dividends for all the years that you need take that average for those years.

    Example:

    Step 1: Obtain the historical high and low stock price for each year

    2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
    Stock Price, High $23.56 $32.31 $38.22 $41.87 $52.97 $41.52 $48.33 $39.54 $47.88 $53.23
    Stock Price, Low $15.22 $24.22 $28.61 $32.17 $41.22 $21.83 $41.72 $32.60 $33.23 $41.38

    Step 2: Calculate the average stock price for each year

    2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
    Stock Price, High $23.56 $32.31 $38.22 $41.87 $52.97 $41.52 $48.33 $39.54 $47.88 $53.23
    Stock Price, Low $15.22 $24.22 $28.61 $32.17 $41.22 $21.83 $41.72 $32.60 $33.23 $41.38

    Stock Price, Average
    $19.39 $28.27 $33.42 $37.02 $47.10 $31.68 $45.03 $36.07 $40.56 $47.31

    Step 3: Take the annual dividend and divide it by the average stock price for each year

    2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
    Stock Price, High $23.56 $32.31 $38.22 $41.87 $52.97 $41.52 $48.33 $39.54 $47.88 $53.23
    Stock Price, Low $15.22 $24.22 $28.61 $32.17 $41.22 $21.83 $41.72 $32.60 $33.23 $41.38

    Stock Price, Average
    $19.39 $28.27 $33.42 $37.02 $47.10 $31.68 $45.03 $36.07 $40.56 $47.31

    Annual Dividend $0.97 $1.05 $1.14 $1.23 $1.36 $1.38 $1.41 $1.45 $1.52 $1.59
    Dividend Yield 5.00% 3.71% 3.41% 3.32% 2.89% 4.36% 3.13% 4.02% 3.75% 3.36%

    Step 4: Take the average of the dividend yield

    (5.00 + 3.71 + 3.41 + 3.32 + 2.89 + 4.36 + 3.13 + 4.02 + 3.75 + 3.36) / 10 = 3.70 %

    Therefore average dividend yield (over 10 years) for this company is: 3.70%

  7. Sorry the tables in my steps 1 to 3 did not turn out so well. The formatting within the comments is limited. :(

    I’ll check with Mark when he gets back from vacation if the formatting can be fixed. Too bad I couldn’t just post a PDF with the fancy columns, and color. :)

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