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Buying a dividend paying stock

Lesson in Course: Stocks (beginner, 8min )

Instead of buying dividend paying ETFs, I want to buy individual stocks with dividends. What do I need to know?

As shareholders in profitable companies, we can expect cash payments from the earnings from the company. These cash payments, or dividends, provide income for us and also other benefits to our portfolio.

Picking dividend stocks

While it's tempting to find the highest paying dividend, the best dividend stocks are companies that have a steady business and consistent profits.

Slow and steady

Companies with stable and growing businesses can afford to pay dividends regularly and grow the amount paid over time. Investors prize these companies for their steady cash flow and have given nicknames to groups of companies. A dividend aristocrat is a company that has increased its dividend consistently over 25 years. In contrast, a dividend king is a company that has increased its dividend consistently over 50 years!

 

A list of dividend kings
 CompanySectorYears 
 American States Water (NYSE:AWR)Utilities66  
 Dover Corporation (NYSE:DOVIndustrials65  
 Emerson Electric (NYSE:EMR)Industrials65  
 Northwest Natural Holding (NYSE:NWN)Utilities64  
 Genuine Parts (NYSE:GPC)Consumer cyclical64  
 Proctor & Gamble (NYSE:PGConsumer defensive64  
 Parker Hannafin (NYSE:PH)Industrials63  
 3M (NYSE:MMM)Industrials62  
 Cincinnati Financial (NASDAQ:CINF)Financial services60  
 Johnson & Johnson (NYSE:JNJ)Healthcare58  
 Coca-Cola (NYSE:KO)Consumer defensive58  
 Lancaster Colony (NASDAQ:LANC)Consumer defensive58 
 Lowe's (NYSE:LOWConsumer cyclical58 
 Colgate-Palmolive (NYSE:CL)Consumer defensive57  
 Nordson (NASDAQ:NDSN)Industrials57 
 Farmers & Merchants Bancorp (OTC:FMCB)Financial services55  
 Hormel Foods (NYSE:HRL)Consumer defensive55  
 ABM Industries (NYSE:ABM)Industrials53  
 California Water Services (NYSE:CWT)Utilities53  
 Stanley Black & Decker (NYSE:SWK)Industrials53  
 Federal Realty Investment Trust (NYSE:FRT)Real estate53  
 Stepan (NYSE:SCL)Basic materials53  
 SJW Group (NYSE:SJW)Utilities52  
 Commerce Bancshares (NASDAQ:CBSH)Financial services52  
 Sysco (NYSE:SYY)Consumer defensive52  
 Altria Group (NYSE:MO)Consumer defensive51  
 H.B. Fuller (NYSE:FUL)Basic materials51  

Think of these companies as the Hondas of investing—they may not be fancy, but they will get you where you need to be safely.

Speedy rabbit

There are other companies in the stock market promising almost double-digit yields. Situations like these are usually too good to be true. 
When a company stretches dividend commitments and has to cancel or cut dividends, the stock price drops, and we incur losses.

Also, we want to avoid dividend-paying companies with significant debt. Interest owed on the debt will eat into the cash available to pay dividends. In the liquidation hierarchy, debt and interest are always paid first before any dividends are issued out. Debt is reported on a company's balance sheet and also in the debt to equity (D/E) ratio for a stock. A good rule of thumb is to choose a company with a D/E ratio below 1.

Calculating the Yield

How do we compare dividend stocks? We can take the dividend payments and convert them to a percentage based on the share price to yield. This % yield informs us of the income-generating potential for each stock.

Example of calculating yield

In February 2020, AAPL’s share price was around $309 per share, and the company declared a quarterly dividend of $0.77 per share. $0.77 is approximately 0.25% of $309—the quarterly yield is 0.25%.

 

Annual yield

To annualize the yield, we would add the dividends from the three previous quarters with a recently declared dividend and divide by the current share price. 

Example of annualizing yield

In the case of AAPL, the company paid out a total of $2.31 in dividends per share before the quarter in February. AAPL paid $3.08 in annual dividends for the year, which is approximately a 1% yield of a share price of $309.

Alternatively, we can estimate an annual yield by taking the current quarter's dividend payment and multiplying by 4 to reach an estimated yearly payout. Then divide the payout by the current share price—$ 0.77 x 4 results in $3.08, which is the same result as above.

 
 

Yield and price

As we know, dividends can affect the stock price. We explain the two main reasons below.

Timing of dividends

When a company declares a dividend, the stock price will typically increase because short-term investors, who did not own any shares in the company, will buy shares to collect the dividend.

After collecting the dividend, these short-term investors would sell the shares, and the price would decrease. Fundamentally, after the company distributes the cash set aside for the dividend, the company value drops because the cash is no longer on the company's balance sheet.

increase or decrease in dividends

Companies cancel or cut dividends in times of trouble, which causes the stock price to drop. The price eventually recovers due to the stabilization effects of yield.

Example of price yield stabilization

 

A $5 dividend paid on $100 per share is a 5% yield, and a $5 dividend paid on $80 per share yields 6.25%. When the yield increases enough to be attractive again, investors will stabilize the share price by buying the stock.

When a company increases dividend payments, stock prices jump due to optimism while a declining yield limits the upward price movement. When the yield drops low enough, investors lose excitement and stop buying.

This push and pull between yield and stock price helps provide dividend stock stability and makes them great additions to our portfolios.

https://www.streetinsider.com/dividend_history.php?q=AAPL

This is a helpful website to look up dividend dates and current yield.

When looking at stocks, we should take note of the dividend yield. A stock with a 5% yield can earn our portfolio a return without even needing to increase in share value. We should also take a look at dividend-paying history and pick either an aristocrat or a dividend king.

Glossary

What is Dividend yield?

The dividend yield, expressed as a percentage, is a financial ratio (dividend/price) that shows how much a company pays out in dividends each year relative to its stock price.

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