Two years ago, I was working full time at a software company, and part time, as a security operator making 12/hr, trying to pay off mortgage debt as fast as possible. At the same time, I was looking for ways to invest money that had been accumulating in my account through a 401K. I had a brokerage account through Fidelity, which allowed me to place stock trades and avoid the limited list of mutual funds they offered. It had started as an “experiment” account, but now I use dividend investing as part of my investing arsenal to earning passive income, and catching the natural drifts in the stock market. Since then, I’ve been very lucky to have realized some gains using this method.
Principle:
The idea is to find a stock meeting the below conditions:
- High dividend yield
- Long history of dividend payments
- Depressed stock price
- Bonus: Near approaching ex-dividend date
1. High Dividend Yield:
Why is this important? Dividends are basically free money that a company pays me, for being a loyal stock holder. Typically companies pay quarterly – i.e. 4 times a year. The higher the “yield”, the happier I am.
Example: A company’s stock price is $15, and it pays a quarterly dividend of 25 cents per share. The yield will be $0.25 per share * 4 (times per year) = $ 1.00 / year
The Yield is:
(Yearly Dividend / Stock Price) * 100
= 1.00 / 15.00 = 6.7%
The above example of 6.7% is considered a “good” dividend, as compared to the current market rate of a savings account, which (as of 4/22/2011), is at around 1.18%.
The argument against a high dividend is that companies typically can use that money for better purposes, such as: research and development, investing in marketing and sales, and growing the company. Companies with high dividends are normally associated with companies that don’t have high growth, and the earnings are fairly consistent – such as energy, oil, licensing, and real estate companies. Sectors which are high growth, such as IT, do not offer dividends that often.
I normally look at the dividend yield as sort of an interest rate that I am putting into a savings account.
2. Long History of Dividends:
Based on the company’s dividend history, I calculate the historical dividend yield (as above), and compare that to the current yield. If the current yield is much higher, there’s a chance that the company may reduce the future dividend, to stay consistent with prior years. I look for at least 5 consecutive years of dividend payments, to give me some confidence in the stock, and reassurance in its ability to continue paying it.
3. Depressed Stock Price:
A company that is down in the market, with analysts hatin’ on them, and media generally dogging them, is good for me. I look at the Price to Earnings ratio to ensure I am getting my money’s worth. The price to earnings ratio is the company’s share price compared to per share earnings.
Example: If a company is currently trading at 30, and it earns $2 / year, then the P/E ratio is: 30/2 = 15.
I generally compare the P/E ratio of the stock, to the P/E ratio of the company’s competitor, and also the sector, if possible. If the competitor’s P/E ratio is much higher, then I would consider the stock price depressed, and move onto the bonus round.
4. Bonus:
When a company declares that they are paying a dividend, they also announce the ex-dividend date.
The ex-dividend date is the last day which you can buy the stock, and get paid the dividend. Normally, this is about two weeks before the day they pay out the dividend, but this can vary. Companies normally announce the ex-dividend date a few weeks before that.
If the company’s price is depressed, and the expected dividend is normal, then the dividend yield can gain a small bump.
Example:
Company A pays a dividend of $0.25 per quarter ($1.00 per year), for the last 5 years.
Company A’s stock price, had a 52 week average of 15, but with some bad media attention, its price is down to 13.
Therefore its yield went from 1.00/15 = 6.7% to 1.00/13 = 7.7%, a 1% gain!
So, if I ask myself, would I be happy if I kept money in this stock for the next 5 years, knowing that I can possibly keep the dividends at this rate? If the answer is yes, then I purchase the stock, before the ex-dividend date.
There is an advantage to this –if stock price rebounds, I normally compare to what I can get if I sell the stock, to the yearly dividend yield. If it is much higher than the yield, I can sell the stock early, and reinvest in other “deals”, as I have realized my gains for the year. Optionally, I can keep my money in the stock, collect the yield, and see if the price increases even more.
For example, as in the above, if I had purchased 100 shares of stock for $13 per share, then I would pay 13*100 = 1300. If the company’s share price went from 13 to 12, assuming I bought the stock before the ex-dividend date, I would still get 100*0.25 = $25 that quarter. I see that the price went down a little, but at least I’m making money. Over the course of the next 3 months, it rebounds to 15 again. Now, my gain is 15-13 = 2 per share * 100 shares = $200. If I were to sell it, then I would have a total gain of 200 + 25 = 225. My overall return would be 225 / 1300 = 17%.
The main idea here is that I still make money through dividends if the share price dips, and I can reap the gains if the share price rises.
For more information on dividends, here are a few good books:
Be a Dividend Millionaire: A Proven, Low-Risk Approach That Will Generate Income for the Long Term
The Little Book of Big Dividends: A Safe Formula for Guaranteed Returns (Little Books. Big Profits)
Note: All entries in this blog are my opinions only, and for entertainment purposes, and should not be used as investment advice, tax strategies, and the like. Please consult an finance or tax professional before investing.