BreakingModern — For many investors, when they think about making money in the stock market, they are thinking about the situation where they sell a stock for more than the original purchase price. In other words, a capital gain. But that is not the only way you can increase your wealth and achieve financial independence using the stock market. Some companies will pay you a dividend just for owning their stock.
Dividends are a distribution of profits to shareholders. When a corporation has profits in excess of what it needs to manage operations, it can share those profits with the stockholders. However, it’s important to keep in mind that not all companies do this and there is no absolute obligation that they do.
Dividend-paying stocks are important because they generate income even if the price of the stock never increases. When looking for stocks to add to your investment portfolio, it’s typically beneficial to include a few dividend stocks in the mix.
However, when considering which dividend-paying stocks to invest in, there is concept you need to understand: Yield.
Yield is the rate of return, expressed as a percentage, generally calculated on an annual basis, for an investment. In the case of dividends, yield is calculated by dividing the annual dividend by the current market price of the stock. For example, as of Jan. 2, 2015, Waste Management, Inc. has an annual dividend of $1.50, which means for each share of WM stock you own for a year, you will receive $1.50 in dividend payments. But how do you compare that dividend to another company’s dividend? AT&T pays an annual dividend of $1.88, but how do you decide if that dividend is better than Waste Management’s? Is it really just 38 cents better?
By dividing the annual dividend by the current market price for each respective stock you can calculate the annual yield. For Waste Management the yield is 2.91 percent and for AT&T it is 5.55 percent. So, AT&T is giving you a better yield that is more substantial than the 38 cents that separates the actual dividend payouts.
Note: Once again, if you use one of the financial information websites like Google Finance, you can get the dividend yield for any company with no calculations required.
Of course, yield isn’t the whole story when it comes to dividends. The real power of the dividend lies in the Dividend Reinvestment Program. Instead of receiving dividends as cash payouts, investors can elect to have each dividend be paid in additional shares of the stock that generated it. Much like compounding interest in a savings account, using DRIP, investors can compound dividends and increase the value of their portfolios exponentially.
Using the basic Rule of 72, a current investment in AT&T would double in about 13 years even if the stock price and dividend stayed exactly the same for that whole time. Your savings account is not going to give you anything close to that rate of return. Add to that the fact that AT&T has consistently raised its dividend for years, and you can see why stock market investing is a better strategy for achieving financial independence.
Dividends and dividend yield are not the only factors investors should consider when choosing stocks for their investment portfolio, but both of these factors should definitely be part of the overall decision-making process. A company that consistently raises dividends is usually a company worthy of your investment dollars. A stock with growing dividends and an increasing market price is the one-two punch that can earn you financial independence in a hurry.
Is there a financial concept or general question you have? Drop me a comment and I will do my best to answer it. Check out the articles I’ve written on how to start controlling your finances:
- New Year’s Resolution: Financial Independence [Part 1]
- New Year’s Resolution: Glossary of Investing Terms [Part 2]
- New Year’s Resolution: Investing without Stress [Part 3]
- New Year’s Resolution: Investment Strategy [Part 4]
For BMod, I’m Mark W. Kaelin.
Note: The information provided is not intended to provide tax, legal, insurance or investment advice. Risk is an integral part of any investment strategy, and you should consult an attorney or tax professional regarding your specific legal or tax situation.
First/Header image: © adrian_ilie825 / Dollar Photo Club
Second/Featured image: © Rrraum / Dollar Photo Club