Dividend stocks is a term that refers to companies that return payments to their shareholders periodically. Some companies pay these dividends every month while others pay the payout every quarter. Other firms pay a dividend once per year.
Now the big question; is this method good only for long time investors or also for day traders? Let's find out in this article, where we will see: how dividend stocks work, why some companies don’t pay dividends, and how to trade such stocks.
How dividend stocks work
The best way to understand how dividend stocks work is to use an example. Assume that you are an entrepreneur who runs a company with two more shareholders. Assume that the company generates $10,000,000 profit in a quarter.
In this case, you can decide to distribute $5 million to the shareholders and save the rest for the rest. The amount that you distribute to the shareholders is known as a dividend. This is simply how dividends work.
Another important concept you will note in investing is on dividend yield. A dividend yield is calculated using the formula below.
|Dividend yield = (Dividend paid / stock price) X 100|
For example, if a company pays a dividend of $0.25 per year and its stock price trades at $50, it has a yield of 0.5%.
As you will find, companies like Apple and Microsoft that are doing so well have a lower dividend yield than troubled companies AT&T. This is because the shares of companies like Apple and Microsoft is so high that it decimates the overall yield.
Companies that pay a very high dividend are mostly preferred by people looking to generate higher returns but who are willing to take more risks.
Types of dividend stocks
There are several types of dividend stocks that you should be aware of.
- REITs - Real Estate Investment Trusts are companies that are required by law to return payments to their shareholders every year. These companies tend to have a higher dividend yield than companies like Apple.
- High dividend yield stocks - These are stocks with a higher dividend yield than the overall S&P 500 average. At the time of writing, the S&P 500 has an average yield of about 4%.
- Dividend aristocrats - These are firms that have increased dividends for 25 consecutive years. They include firms like Coca-Cola, Nucor, and Caterpillar. There are about 65 dividend aristocrats today.
- Dividend kings - These are firms that have increased dividends for 50+ years. They include Procter & Gamble, 3M, and Lowe’s.
- Monthly dividends - These are companies that pay dividends every month. Most of these firms are REITs and Business Development Companies.
Examples of dividend stocks
There are hundreds of companies that pay a dividend. Some of the best-known dividend stocks are:
- Johnson & Johnson.
- Realty Income
Why companies don’t pay dividends?
While many companies pay a dividend in the United States, the reality is that others don’t pay a dividend. Yet, in terms of performance, companies that don’t pay the payouts tend to perform better.
A good example of a company that does not pay a dividend is Berkshire Hathaway. The firm has more than $130 billion in cash but it has avoided paying back the funds.
Many companies don’t pay dividends because they want to have cash at hand to fund growth without adding a lot of debt. Some of the top companies that use this approach are Facebook and Google. The two firms have more than $200 billion in cash.
Other companies fail to pay dividends because they think that other options of returning cash to investors is better. Indeed, companies like Berkshire Hathaway, Facebook, and Google have returned billions of dollars to shareholders through share buybacks.
Another reason why companies don’t pay dividends is to have dry powder that they can use to acquire other companies and fund investments.
Share buybacks vs dividends
There is usually a debate about the better option of returning funds to investors. On the one hand, there are those who believe that dividends are better while others believe that buybacks are better. Other investors prefer companies that combine both buybacks and dividends.
Share buybacks is a process where a company allocates funds to buy back its shares. By so doing, the firm reduces the number of outstanding shares and then increases the earnings per share. Also, share buybacks are signs that a company is confident of its business.
Still, in our honest opinion, We think that dividends are superior. For one, in the past, we have seen companies like General Electric crash even after spending billions in buybacks.
How to trade dividend stocks
From the onset, we recommend that day traders should diversify their incomes by setting aside some funds in a dividend-yielding account. They can do this by allocating funds in individual dividend stocks or in dividend ETFs.
Next, trading in dividend stocks is similar to how you trade other companies. This means that you need to do your technical and fundamental analysis. You should combine these with price action analysis. By so doing, you will be at a good position to identify moves early and move with the flow.
The only difference when it comes to dividend stocks is when the firms go ex-dividend and when they hike or lower their payouts. In most cases, the stock tends to rise ahead of when the company will pay the payouts. This is primarily because investors tend to buy the shares in advance as they prepare for the next payout.
As a result, using the dividend calendar (as for the entire economic calendar) will help you know the firms to trade.
The chart below shows how a dividend calendar looks like.
Dividend stocks are mostly preferred by people looking for long-term returns. To do this, they look at the payout ratio and the health of that dividend. The worst thing that happens is when a company decides to cut its payout. They do this either to fund an acquisition or because their business is going through challenges.
This is not to say that there are no opportunities for day traders, but these can only be exploited in a short period of time. Therefore, it is necessary to have a strategy ready.