What are dividends?

Dividends is a percentage of profit that a company divides between its shareholders. Basically a way to let investors know they are happy that you wanted to invest in them. It’s a reward for loyal shareholders. This way, investors can get a return on their investment. This can certainly add up over time when reinvesting the dividends. This can grow exponentially (compounding) because each time you reinvest you can buy more shares (if the price stays the same) and earn more dividends because you have more shares. That might make you think that any company that is paying dividends might be a good option. That is a very common misconception.

Dividends are mostly calculated by looking at the dividend yield. The dividend yield is calculated as follows:

Annual dividend per share / share price

There are a few risks you should be aware of:

In case stock prices are plummeting, the dividend yield will rise.
Companies that are paying dividends are not using this money to grow the business.
Capital gain can drop while dividend payments stay the same.
Interest rate risk

Because dividend yields are based on the price per share, any drop in price will cause the dividend yield to rise. Looking for the highest dividend yield companies by just looking at the highest yields is useless. You need to know why the dividend yield is high.

Dividends are a percentage of the profit a company makes. Meaning, they don’t use this money for growing the business. Is this because they have trouble growing or just want the investors to be happy? Does the business have an excess of money or are there other reasons to pay out dividends? In theory, every company wants to expand to make more money. And most of the time they need money to expand. From that perspective, it does not make sense to pay dividends. On the other hand, paying dividends might attract more investors thus more money.

Another pitfall for dividend investors is losing capital gains while dividends remain high just to keep investors happy. A dividend stock is still a stock that can drop in price. If the stock price gradually but slowly degrades over time while remaining the same dividend percentage, capital gains are degrading at a higher pace then you can keep up with dividend payments. For example:

Stock A, worth $50 paying 3% quarterly dividend.
You buy 200 shares * $50 = $10.000 worth in stocks.
Over time, the share gradually drops in price from $50 to $45, from $45 to $40, from $40 to $35.
But because the company wants to keep investors happy, it still pays 3% in quarterly dividends. Actually, because of the stock price declining, the dividend yield will rise.

If you only look at the dividend yield, there seems to be a steady income flow. But the share price dropped from $50 to $35 meaning you lost $3000 in capital. The stocks are only worth $7000 ($35*200) compared to the $10.000 you invested. So it looks like you got a steady paying dividend yield but in the meantime you lost a lot of money because the stock price declined.

Chasing dividend yields has backfired on many investors. That does not mean dividend stocks can’t be a part of your portfolio. There are many big companies that have an excess of money that are paying dividends for many decades. One of the best examples is Coca Cola.

In simple terms, companies that have a solid business and have a conservative approach on money management are able to pay dividends for many decades. Considering the business and market Coca Cola operates in, they will probably pay dividends for decades to come. Key point is to make sure why the company is paying dividends and how that is related to their current operations.

Another thing you should be aware of is interest rate risk. To remind you, interest rate risk is the risk involved when the overall interest rates (determined by the FED or other central banks) are rising. Dividend yields may stay the same but if the overall interest rate is rising that makes your dividend less valuable. A high dividend yielding stock has a lower risk of interest rate risk but a higher risk of other factors explained above. And the opposite is also true. Lower dividend yields have lower risk of the factors above but have a higher interest rate risk. For example:

A dividend yield of 3% with an overall market interest rate of 1% gives you more value/buying power vs 3% dividend yield and an overall market interest rate of 3%

At this time of writing (2021/2022) this can be an important factor because overall interest rates are historically low and inflation historically high. There is only one way interest rates will go and that is up.

Key Concepts:

Dividends are a percentage of companies profit paid to its investors.
For investors, dividends are considered a passive income.
Dividends are paid annually or each quarter.
Dividend yield shows annual dividends paid to shareholders as a percentage based on the current price of the share.
In case stock prices are plummeting, the dividend yield will rise.
Companies that are paying dividends are not using this money to grow the business.
Capital gain can drop while dividend payments stay the same.
Dividends are prone to Interest rate risk.