dictionary.jpg

5 Dividend Terms To Know For New Investors

DRIP

What is DRIP?

DRIP is an acronym that stands for dividend reinvestment plan. Cash dividends that are paid out by the company are automatically reinvested in the stock allowing your investment to compound over time. This method allows an investor to accumulate more equity in their holdings over time. DRIP does not take in consideration the trading price, hence even if an asset is deemed to be overpriced, with automatic reinvestment you will be better off in the long run.

Key Takeaways

  1. DRIP is used to gain more equity in your investment by reinvesting dividends 

  2. Shares usually come directly from a company’s reserve, not a stock exchange.

  3. There is no commission taken by a broker when reinvesting your dividends 

  4. DRIP is not limited to whole shares; dividends can be reinvested as fractional shares.

Benefits

Since DRIP reinvests your dividends back into the company, one of the significant advantages is dollar-cost averaging. Utilizing DRIP throughout your investment, you can acquire equity at different price points, ensuring that you are never buying at the highest point possible. Companies that incorporate DRIP in their investing ideologies tend to offer the discounted share prices, usually, 3-5 percent when you reinvest your dividend back into the company. Throughout your investment, you will acquire a better dollar cost average than most investors that buy on the open market. 


Dividends

What Are Dividends? 

Dividends are a portion of a company’s earnings that get distributed to the shareholders. Shareholders that hold the asset before the ex-dividend date are eligible to receive the distributed income as cash or in the form of additional shares (DRIP).

Key Takeaways

  1. Dividends are decided and managed by the company’s board of directors.

  2. Typically a stock’s price can fluctuate based on if a company announces a dividend increase or decrease during their earnings call.

  3. Dividends are seen as the token of trust between investors and companies as investors that periodically receive rewards for their investment typically tend to hold their investments for longer. 

Benefits of Dividends

There are a plethora of benefits associated with dividends. One of the essential aspects of dividends is the accumulation of equity in a company over time if the investor utilizes DRIP. Dividend aristocrats (companies that have increased dividends 25 years in a row) have shown to have higher returns in the long run for investors than typical growth stocks. Investors that are price sensitive can reduce the overall volatility of their portfolio in turbulent times, which is especially important for long-term investing. Companies that have shown to have a robust dividend-paying history manage their capital more conservatively and tend to have less internal problems than non-dividend-paying assets. The dividend system is vital to an investor; thus, companies that pay dividends will tend to keep the best business practices to ensure their investors continue to hold their investment in the company.


Dividend Yield 

What is a Dividend Yield? 

The dividend yield is a company’s annual dividend by  its stock price. The annual dividend is usually paid every fiscal quarter, but there are some exceptions such as monthly, bi-yearly or special dividends. 

Dividend Yield = annual dividends per share/price per share

Key Takeaways 

  1. A good dividend yield is usually around 4-6%, which strikes the balance of stable dividends and strong business fundamentals.

  2. High yields are not always a good indicator as those companies have a higher chance of cutting or suspending dividends when they are faced with financial troubles.

  3. Mature companies usually have the best dividend yield.

 About Dividend Yields 

Dividend yields are a good indicator of strong business fundamentals. Since it’s a percentage relative to the stock price it changes continuously, as a result, do not be discouraged from investing in companies that have a low dividend yield but a high stock price versus a higher dividend yield and lower stock price. Historically, real estate investment funds, master limited partnership and business development companies tend to have a higher average dividend yield but be careful in investing as the dividends from these are taxed based on income and are not subject to the capital gain tax like many other dividends. Dividend yields can be used to explore investment options that can give the best compounding investment that suits many different investment styles.

Example of Dividend Yield

Let’s take a look at two companies: Company A and Company B

Company A

    Stock Price: $50

    Annual dividend: $3

    Dividend Yield: 6%

Company B 

    Stock Price: $100

    Annual dividend: $3

    Dividend Yield: 3%


ETF

What is an ETF? 

An exchange-traded fund (ETF) is a collection of securities that is tracked by an index. Unlike mutual funds, they are traded throughout the day like standard stocks.

Key Takeaways 

  1. ETFs can range to include only US holdings to ETFs that specialize in international stocks

  2. Expense ratios differ by the broker but are typically less than what commission would be if you were purchasing a stock 

  3. ETFs can track in many sectors of the economy. Oftentimes including stocks from many sectors to reduce volatility.

Benefits of Exchange Traded Funds 

ETFs are a great tool to diversify your investment portfolio. With hundreds of ETFs to choose from, many choices cater to many styles of investing. An investor that has limited capital to purchase stocks can invest in a wide array of sectors hence reducing the risk of volatility impacting their portfolio. Some examples of well-known ETFs are SPY, QQQ, NOBL and DIA. Most ETFs are managed by companies like BlackRock, ProShares and Invesco. These companies are incredibly transparent with the holdings, and investors can check every day after hours to see what assets were bought or sold within the ETF.


Payout Ratio 

What is a Payout Ratio?

The payout ratio is a metric that shows the share of earnings that are going to be paid as dividends by a company. 

PR = Total Dividends / Net Income 

Key Takeaways 

  1. A low payout ratio is usually an indicator that the company is holding money from dividends to expand operations 

  2. In some rare cases, there is a payout ratio of over 100%, but those are regarded as extremely risky. There are some exceptions of REITs that have a payout ratio over 100% as they are designed solely for dividends. 

About Payout Ratios 

The payout ratio is an important metric to see how funds are allocated back to the investor. A high payout ratio is not always a good indicator as it reduces capital that could be used to expand business operations. A payout ratio between 35-55% is considered healthy, but there isn’t a set benchmark as companies operate at different scales. Investors should look for payout ratios that are sustainable to provide enough income for dividend investors but at the same time, allow the company to grow. 

Examples of Payout Ratio

Let’s take into consideration company A

Company A reports earnings of $2 per share and a dividend of .75 cents per share. 

The payout ratio would be 37.5% . The remaining 62.5% is kept by the company, also known as the retention ratio, which allows for business expansion of company A.

Formulas

.75/2.00= .375*100=37.5% (Payout Ratio)

100%-37.5%=62.5% (Retention Ratio)

Final Takeaway

The world of investing comes with a steep learning curve. There are many terms and formulas used to identify potential investments. Like any other craft out there, if you want to get better at investing you need to learn the basics. The world of finance is immersed in complicated terminology that could confuse the novice investor but learning the basics will go a long way in understanding the financial markets which will ultimately lead to better financial decisions in the future.

Written by: Armand Bogdan
Published on: Tuesday, July 7, 2020 4:00 PM

Reach your dividend goals