It's back to school time, folks. Well, not for me, but it is for many. So with that in mind, let's take a look at the basics of dividend investing and what makes dividends an intriguing investment option for a portfolio.
What is a dividend?
A dividend is a cash payment made by a company to its shareholders. These cash payments are most often made quarterly, but they can also be made bi-annually or annually. In some cases, companies will also pay special dividends -- as Quality Systems (NASDAQ:QSII) did earlier this year.
In most cases, companies pay out the green stuff because they have the cash necessary for daily operations in the bank, have funded any expansion plans, and still have money left over. As a company grows, its dividend payment will most likely grow as well. This growth is important because it allows for additional investments and increasing cash flow into a portfolio.
What is a yield and how is it calculated?A dividend yield is a simple yet handy metric that allows investors to compare the percentage cash return on the purchase of one share across companies. For example, a share of ExxonMobil (NYSE:XOM) sells for $64.71 as I write this and pays an annual dividend of $1.28 per share. The dividend yield in this case is:
$1.28 / $64.71 = 1.98%
A look at Chevron shows its yield to be 3.3%. The higher the yield the more you will be paid during the first year of investment. It's important to note that a high yield doesn't necessarily mean that a company is paying out a large portion of its earnings or cash flows as dividends. It also doesn't always mean a stock is attractively valued (or unattractively valued). A yield is only the percentage of cash that you'll receive -- just like it is for a savings account.
The payout ratioTo get an idea of how much cash a company is paying out requires looking at its dividend payments in relation to its earnings or cash flows. The easiest way to do this is to divide dividends paid per share by diluted earnings per share. For example, in the past 12 months Nike (NYSE:NKE) earned $5.28 per share and paid out $1.18 in dividends. In this case, the payout ratio is 22.3% ($1.18 / $5.28).
But this isn't the best way to look at a company's payout ratio because earnings are from the income statement and are based on accruals, not cash. Dividends, on the other hand, are cash payments and require cash flow, not earnings, in order for the company to be able to pay them reliably over the long term. The math to calculate a cash flow-based payout ratio is the same as it was above, but the inputs are different. First you'll need to determine a company's free cash flow, and then the dividends paid can be divided by free cash flow. The basic definition of free cash flow is:
Free cash flow = Cash from operating activities - capital expenditures
All of the items required for the calculation can be found on a company's statement of cash flows. Continuing with Nike as our example, we see that the company had $1.67 billion in cash flow from operating activities last year and spent $333.7 million on capital expenditures, making free cash flow $1.33 billion ($1,670 million - 333.7 million). The company also paid out $290.9 million in dividends in its last fiscal year, makings its cash flow-based payout ratio 21.9% ($290.9 million / $1,330 million).
For Nike the difference between the two ratios is not large, but for other companies, it can be. And since dividends are cash payments, cash flow payout ratios are more relevant than earnings-based payout ratios. However, keep in mind that it is important to look at multiple years of data to get a true picture of how well a company is funding its dividend. One year with an 80% payout ratio might be concerning, or it might just be a blip on the radar.
Where to look for dividends
So far we've seen a software company, an integrated oil company, and a shoe and apparel manufacturer that all pay dividends. In other words, dividend-paying companies can be found in just about any industry. And while the best-known are utilities, real estate investments trusts (REITs), consumer staples such as Procter & Gamble (NYSE:PG), and conglomerates such as United Technologies (NYSE:UTX), dividend payers can also be found among retailers such as Buckle (NYSE:BKE) and even small caps. (Incidentally, it can be quite rewarding to hunt for undervalued dividend payers among companies capitalized at less than $2 billion.)
Why focus on dividend-paying stocks?
Of the many great reasons to focus on dividend paying stocks, two stand out to me. The first is that dividend-paying stocks must back up earnings statements with cash dispersals, making it more difficult for them to account creatively. Second, dividends allow you to continually reinvest new money in the stock market without having to fund your account from savings. Although I try to regularly add money to my investing accounts, it doesn't happen as often as I'd like. Dividends make it automatic.
With an understanding of dividends under your belt, the next step in evaluating any dividend-paying company is to understand its valuation. This article can help you get started down that path.
Or if you'd like to learn more about dividend-paying stocks and companies that could make attractive additions to your portfolio today, consider a 30-day free trial to Motley Fool Income Investor. Focusing on dividend-paying companies has the service beating the market by five percentage points since inception. Click here to learn more.
At the time of publication,Nathan Parmeleehad no financial interest in any of the companies mentioned. Quality Systems is a Motley Fool Stock Advisor selection. The Motley Fool is investors writing for investors.
