Looking to diversify your portfolio with stocks that reward your investment but don’t have the volatility of growth stocks? Dividend investing may be for you. Dividend-based investing provides an opportunity to invest in companies with a history of paying dividends to investors, providing a return on investment. But, before you jump headlong into the dividend-stock pool, familiarize yourself with basic terms, such as dividends and dividend yield, to make the best-informed purchase.
Dividends: Boardroom to Investors
At its heart, a dividend is just a slice of its profits a company distributes to shareholders. After a company calculates its net profits for a quarter, it can choose to reinvest in growth, pay down debt or horde cash in an emergency fund. But it can also move to pay a dividend to investors. Because of this, dividend stocks are usually from companies that have a large amount of cash and low debt-to-earnings ratios.
Dividends in Action
When a company decides it’s time to reward investors with a dividend, it allocates a portion of its cash on hand to do the job. It divides the amount by the number of outstanding shares to get the dividend to declare. Each shareholder receives that dividend per each share of the stock they own. For example, if you hold 100 shares of Widget Co. stock, and it declares a $2 dividend, you can expect a $200 dividend check -- or $2 x 100 -- to show up in your mailbox in the near future.
Dividend yield provides an easy way to determine how much return on your investment each dividend stock provides. It’s calculated as annual dividend divided by the price of the stock, and is expressed as a percentage. This is helpful to compare investments. For example, if shares of Widget Co. stock trade at $100, the year it declares a $2 dividend, its dividend yield is 2 percent, or $2 / $100. This shows that if you invested your money in a CD that had a return of 2.5 percent, you would have more profits at the end of the year.
Applying Dividend Yield
It’s essential to examine dividend yield when considering stock purchases. Consider two stocks: Widget Co., with its $2 annual dividend, and Acme Inc., which paid $1.50 in dividends. To the inexperienced investor, Widget Co.’s higher dividend may seem like a better investment. By applying dividend yield, however, we can see that’s not the case. Widget stock costs $100 per share, resulting in a dividend yield of 2 percent. Acme stock trades for only $50 a share, so its yield is 3 percent.
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