Imagine having an addition paycheck coming to you every quarter. Think of it as a secondary quarterly bonus that is not tied to your employment. With stock trading this type of income stream is available to you!
As we have discussed in previous lessons, the main goal of stock trading is to buy at a lower price and sell at a higher price. This will generate profits in your account. A secondary source of profit from stocks is going to come from dividends in the companies that you are invested in. Unlike profits from buying and selling, this income is locked into place at a set rate and is paid to you on a periodic basis. In this article, I’m going to be covering the basics of dividend payments and how a dividend reinvestment plan can dramatically increase the size of your account.
What are Dividends?
Dividends are simply distributions of a company’s profits to its shareholders. Investors who buy stock are entitled to dividends only when the company’s board of directors votes to make distributions. Stockholders are automatically sent any dividends for the amount of shares they hold in their account.
When you buy a stock, you will be able to see if it pays a dividend or not and what the yield is on that dividend. When I say yield I am referring to what percentage of payout you can be expecting.
Dividend Yield= Annual Dividend/Current Market Value of the Stock
For example, looking at Microsoft we can see that it pays an annual dividend of $1.56 and it is current trading at $60.35. For that reason, the dividend yield=2.58% (1.56/60.35)
How are Dividends Paid to Shareholders?
Typically, almost all dividends are paid to shareholders quarterly unless the company stipulates otherwise. The company will decide what amount of money per share they choose to give back to shareholders. As an example, a company may decide that it’s going to issue a dividend of .25 cents per share. If you owned 100 shares, then you would receive a dividend payment of $25 dollars every quarter in which you hold the stock.
Stock Price Reduced
So we know now that this dividend income is guaranteed to the investor. The problem lies with the underlying value of the stock. Let’s say you wanted to buy 100 shares of Microsoft stock to get a $25 dollar dividend every quarter. The inherent risk is that your underlying principal could lose a great deal of value in the time that you are receiving dividend payments. The value could fall so much that your $25 dollars every quarter does not offset the losses you are taking on in your principal. It’s always best to be mindful of this if you are looking to invest in a company because they have good dividend payments.
Shared holders who are paid a dividend have the right to receive the dividend as a cash payment or elect to participate in a dividend reinvestment plan. What this means is that the dollar figure you receive as a dividend is automatically taken and used to buy as many shares as possible of the underlying company.
Let’s say you own 1,000 shares of Disney and it pays a dividend of $0.75 cents a quarter. Disney is currently trading at $50 dollars a share. You can elect to receive your dividend as a cash payment ($750 dollars) or you can choose to reinvest those dividends and acquire 15 more shares of Disney ($750/$50 per share= 15 more shares).
Power of Reinvestment over time
Dividend reinvestment in a good growth company over time is extremely lucrative. You acquire more and more shares so you get paid more in dividends each quarter. In addition, you experience more upside growth as you soon develop a larger position in the company. Let’s take a look at an example.
I will choose Verizon as the company because they have a great dividend yield of 4.7%. Let’s say you invest $5,000 dollars in VZ and decide to make annual contribution to the stock of $500 dollars per year (pretty minimal as far as savings go). Assuming a 6% average annual growth rate in the stock, your $5000 dollar investment in 30 years would now be worth….
Whooaa, the power of compounding and dividend reinvestment really went to work for you! You guys have to always see the big picture. Investing is a marathon and we can all reap the benefits if we have patience and let our investments do the work while we sleep.
Homework: Take a look at some stocks with dividend yields of 3% or greater and see what their performance has been like over time.