When a corporation turns a profit, it has two choices: It can keep the profits and reinvest them in the company, where they become retained earnings, or it can distribute them to the shareholders. That distribution is a dividend.
Dividends can take several forms. A company can issue a stock dividend in which additional shares are distributed to existing shareholders, or it can issue a dividend of property. The most common dividend, however, and the one that tends to adhere to a regular payment schedule, is simply a cash payment distributed on a per share basis.
In the world of dividends, not all shares are created equal.
Common stock, the kind issued by every corporation, may or may not have a qualified dividend. If it does, the Board of Directors will declare the dividend amount at the company’s annual meeting. The company then pays on an announced schedule, whether annually, quarterly or monthly. Like the share price itself, the dividend can change with the company’s fortunes. If times are especially bad, the dividend can be suspended.
Preferred shares are different. When issued, those shares come with the company’s promise to pay dividends at a set rate, the coupon rate, while the shares are outstanding. The coupon rate is set when the shares are issued, so that initial investors can anticipate a certain dividend yield going forward. Like common stock, however, preferreds are traded on the open market where share prices rise and fall. Since later buyers pay a different price for their shares, their dividend yield will differ from the initial coupon rate for better or worse.
Top dividend stocks tend to be those with regular and predictable earnings, making banks and utility companies prominent in the dividend-paying universe.
The Payment Schedule
In theory, companies can pay dividends on any schedule they choose, but most pay quarterly or annually. There are many companies that pay monthly, though, and that schedule has some advantages.
First, many investors, especially those interested in stable retirement income, prefer the smooth, steady monthly payments to a quarterly schedule, for example, that delivers a lump sum in one month and leaves two months cash poor.
Second, investors get their money faster and are better able to take advantage of compounding the yields on the dividends themselves.
Third, stocks that pay monthly tend to be less volatile than those that pay quarterly or annually.
What to Look For
Net Income Growth
Net income is a function of many factors, including revenue, cost of goods, expenses and operating margins, all of which interact and can play a part in a company’s profitability. Since it attests to the company’s increasing profitability, net income growth is a positive sign of continued dividend payment.
Dividend growth is another sign of corporate health and profitability. Long-term returns are amplified by dividend growth and investors should consider this variable at least as seriously as the dividend yield itself.
Return on Investment
Ultimately, return on investment is a global measure of the totality of an investment’s performance. It takes into account changes in the share price, dividend yield, the schedule of payments and the possibility of compounding returns over time. Dividend-paying stocks should be evaluated in light of all factors that contribute to an investment’s total return.
Low payout ratio
The dividend payout ratio is simply the amount of the company’s dividend divided by its earnings per share. A company that pays out all of its earnings would have a payout ratio of 100 percent, while a higher payout ratio means that the company is paying out more than it is actually earning. This is not generally a sustainable practice. Although an extremely low payout ratio may lead a dividend-focused investor to question the use of those additional earnings, a low payout ratio is a comforting sign of a safe dividend that is likely to continue. As a rule of thumb, a payout ratio below 60 percent is one sign of a stock worthy of an investor’s serious attention.