I thought about writing about dividend stocks for a while.
This idea came up to me after I started my Twitter account for the blog. I saw people being very excited about dividend stocks more than any other kind of stock.
The frenzy is so strong that they buy only stocks paying dividends.
I will go over here about what I think of dividend stocks and why.
For me, it starts with how I determine the return I make on a stock. I calculate the total return as:
Dividend yield + Capital gains yield = Total stock return.
The dividend yield is equal to: Annual Dividend Payment ÷ Current Market Price.
Capital gain being equal to: Ending stock price – Purchase price ÷ Purchase price.
Understanding income stocks
So what’s special about these companies paying dividends?
These are companies that are in the maturity phase. This means that they have been operating in their industry for decades.
Fortunately, at their level, there is a lot of profit generated. This gives them flexibility.
Each year they have to decide whether to take the profits and reinvest them in the company or distribute the profits to the shareholders.
But what tips the scales one way or the other?
It’s opportunity.
If the company doesn’t have an opportunity to expand the company, release a new product, buy another company, etc…
They will distribute the earnings. In other words, if you don’t have a better use for the money distribute it.
So if we go back to our formula at the beginning, it means that you will have a dividend yield but a low capital gain.
Your decision to choose a stock should be weighed against any other alternatives you may have. Just aiming for a high dividend yield doesn’t mean you’ll be better off overall.
A stop in the dividend payout or a decrease is going to be damaging for your return and in addition, you won’t even be compensated for the drop of return by the capital gain.
Moreover, the price you pay for the stock is to be weighted in the decision, because a high stock price decreases your dividend yield.
For example:
A company that pays a dividend of 24$ annually and is priced 120$, we get a dividend yield of 24$/120$ = 20%.
On the other hand, a company that offers a dividend of 36$ and is priced 200$, we get a dividend yield of 36$/200$ = 18%.
Final note
I want to clarify and emphasize that I’m not against investing in income stocks.
What I’m saying is that you shouldn’t invest in a stock solely on the basis of one criterion, which is that it is a high dividend stock.
An income stock has its merits. If you are at a point in your life where you need a steady stream of income, income stocks are a good bet, but if you can afford to stay invested for many, growth stocks will reward you.
The decision of picking a stock over another must be made following in-depth analysis.
Moreover, to have a well-diversified portfolio different types of stocks and asset classes should be incorporated.