The Truth On Dividend Investing (Can You Retire Off Of Dividends?)
Dividend Stocks have become a hot topic over the last year.
Just take a look at this google trends chart that I’ve pulled up on the term “Dividend Investing.”
These numbers on the X-axis, represent the magnitude of the search interest over time, where a value of 100 indicates peak interest, and a value of zero indicates no interest at all or not enough data to show. As you can see — starting from the 2nd half of 2019, the term “Dividend Investing” started to rise in popularity, touching the peak of the chart twice already.
And even just a simple search online will bring you thousands and thousands of articles and videos on this topic. And what’s really interesting is that a good number of this content, loves to focus around finding ways to live off of these dividends — but they’re really only scratching the surface of what dividend investing is.
So today, in this article, we’ll dive into all of the details around what dividends are, how they work, and some core truths you need to know about dividend stocks before you invest in them.
What are dividends?
So let’s start off at the very beginning and establish a baseline understanding of what dividends are.
Simply defined, a Dividend is a regular payout that is typically made quarterly by a company to its shareholders out of its earnings — to reward them for being a stakeholder in the business.
As you guys already know — every company on a US stock exchange reports earnings on a quarterly basis and when they report earnings or net profit, a dividend paying company will take a portion of that profit & distribute it back to each shareholder, in proportion to the number of shares they own as a “thank you” for taking part in the ownership of the company.
Who offers dividends?
Now you might be wondering, why don’t all companies do this? Why are there only certain groups of dividend yielding stocks?
Well, dividends are typically characteristic of seasoned, tenured companies. Larger and more stable blue chip companies generally offer dividends because they have long-standing & well-practiced business models that provide enough scale and margin in their P&Ls to allow for dividends. Additionally, these long established companies tend to have more steady growth rates that aren’t subject to sudden spikes — and are therefore less in need of ad-hoc injections of working capital outside of their typically forecasted budgets.
In contrast, when you have new start-ups or much smaller companies, they are in a constant phase of hyper growth and therefore need to reinvest every dollar they can earn, to help scale their business upward. And in nascent business models, you never know when something critical might come up that suddenly needs a influx of funding.
So it would be harder for a company of a smaller size to siphon off a portion of their earnings, to allocate towards dividends — which is why you typically see dividends in larger, long standing businesses.
How do companies decide how much to pay out?
Now for those companies that are dividend paying, how do they determine how much to pay out at each dividend distribution? Well, that depends on what approach each company takes in their dividend policy.
There are 3 general approaches to dividend policy.
1) Residual Approach
The first is call the Residual Approach, and the basic definition here, is that a company takes its earnings to first fund their capital expenditures, and then with the surplus, pays dividends to its shareholders.
Here’s a quick example of how this works.
Let’s say there is an imaginary company called Edison, which manufactures electric cars and competes with the likes of Tesla and Nikola Motors. Neither Tesla nor Nikola pay out dividends to their shareholders, so Edison wanted to differentiate themselves by providing one.
Let’s say Edison’s core focus was delivering a new electric vehicle that’s to be completed at the end of this quarter — and let’s say that it cost $100M to complete this car and that the company earnings for this quarter was $125M.
In the Residual Dividend Approach, Edison would first cover the capital expenditure of $100M with their earnings — and then with the remainder, pay out the dividend to its shareholders.
In this approach, the amount of the dividend is always based on what is left over or residual from paying off the investments and projects that the company has within their time frame. And since the costs of the company’s initiatives can vary from time to time, what this means, is that in the Residual approach, the value of the dividends would change drastically each quarter based on the amount of CAPEX (capital expenditures) the company spends and how much their earning are for that period. So in one quarter, the dividend payout might be great — but in the next quarter, your dividend value could be next to nothing.
2) Stable/Smooth Approach
The next dividend approach is called the Stable/Smooth Approach.
In this method, the company sets a steady or constant distribution percentage based on each quarterly or yearly earnings and pays out that portion first regardless of what their capital expenditures or earnings are.
Basically, the company aims to provide a steady payout percentage of dividends regardless of how the business performed that period. This approach is usually adopted by large, margin rich companies that can afford to pay regular dividends — even if their P&L weathers some storm throughout the year. The benefit to this approach, is that for the shareholders, there is more likelihood of a constant flow of dividend payments that does not fluctuate as wildly in amount, at each payout.
3) Hybrid Approach
And the 3rd approach is a Hybrid Approach that combines both a residual and steady component.
Typically a company that follows this approach sets a small baseline percentage for their steady dividend component, that they are confident that they can hit every quarter. They then supplement that amount with what is left over from the investments and projects that the company has within the quarter. From an investor standpoint, this means that there is still some volatility in how much the dividend payouts are each period, but it would fluctuate less than a company that employs a straight residual dividend policy — because a portion of the dividend is steady and consistent.
How are Dividends paid out?
Now, the next thing you have to know about dividends is how they are paid out.
And the first step in understanding this, is learning about the series of dates that you need to keep in mind, as a company goes through the distribution process.
A) Declaration Date
The first is the declaration date. Before each dividend payout, usually a few weeks before, the company makes a public announcement, on this date, outlining the following 4 things: Size of Dividend, Record Date, Ex-Dividend Date, Payment Date.
The size of the dividend payout is usually expressed by a value per share, so as an example, in June 2020 Microsoft’s most recent dividend declaration was $0.51 per share. So if you were holding 100 units of Microsoft stock — under this dividend policy, you would be dispersed $51.
B) Record Date
Next is the Record Date — which is the date where the company reviews all of its shareholders to determine who is officially an owner of their stock and therefore eligible for this dividend.
C) Ex-Dividend Date
Then we have the Ex-dividend Date — and this might be a bit confusing because this is the actual date in which you need to hold your stocks through, in order to be considered for dividend payment. You see, because of the way the stock exchange process works, when you buy a stock, it takes 2–3 days for that transaction to settle in your brokerage account, before you are the official owner of the stock. Until then — the stock that you bought is in a pending or unsettled status. So, to make sure each shareholder is an official owner of their stock, a dividend yielding company takes a snapshot of all of their shareholders on the Ex-Dividend date. Then after 2–3 days, the data in that snapshot is processed and sent to the company’s board of directors who examine that information and make a determination, on the record date, about who is an official owner of their stock.
So an ex-dividend date is always set about 2–3 days before the official record date. And as you can see, the ex dividend date is the most important — because that’s the date that determines whether or not you are in the consideration set to be identified as an official owner of the stock. So, if you want to make sure you receive a dividend payout, what you’ll want to do, is make sure that you buy and hold your stock before and through the ex-dividend date.
D) Payment Date
And lastly, the payment day is simply the date in which the pay out is distributed to your brokerage account.
So — now that we’ve defined what dividends are and how they work, here are some key things you also need to know about dividends and dividend stocks.
Important things to know about Dividends
First, one really important thing to know about dividends is that when the ex-dividend date is announced and subsequently distribution happens, the share price of the stock drops according to the amount of the dividend that the company is releasing. This means that all of a sudden you could see a pretty noticeable drop in the share price of the stock, for that day.
This happens for 2 reasons, first, you can choose to receive the dividends in one of two forms — either in cash which would just get deposited in your brokerage sweep account, or if you are enrolled in a Dividend Re-Investment Plan or otherwise known as DRIP — the dividends are paid to you in the form of more shares of that stock. The DRIP option of receiving more shares for your dividend is pretty popular, and in this method, the company has to issue each shareholder that selects this option, more incremental shares of their stock — which dilutes the overall market cap, and thus the share price drops to reflect that.
This is a really important thing to know — because if you’re new to dividend investing, seeing a share price drop of around 4–6% all of a sudden after the dividend is declared is a scary thing to see — but don’t worry, it’s all a normal part of the process.
And the second reason this would happen is that regardless of whether the shareholders take their distributions in cash or DRIP, when the dividend is announced, it becomes public information and the market price of the shares reduce to the extent of the dividend declared because for new potential buyers of the stock, who are NOT eligible to receive the dividend, they should be able to buy the stock at the adjusted price after that a portion of the profits have gone out of the company, for it to be a fair transaction.
So simply put — the dividend payout comes out of the earnings of the company so when that happens, the total value of the company is slightly diminished in the short term. Therefore the price of the stock reflects this.
And this is where the bulk of the dividend information out there gets it wrong.
You see a dividend isn’t just free money on top of owning the stock — the value of the dividend is actually taken out of the total market cap of the company and simply redistributed back to you.
So knowing this, the big glaring question would be, “Then why would dividend stocks be any better than growth stocks that don’t pay out dividends — I mean whether the company separately distributes a portion of their earnings to their shareholders, or retains it within their stock value — the total value of your investment would be the same, no?”
Yes, initially this is true but the argument FOR dividend stocks, is that most of them usually recover that drop in price very quickly after the payout date. And that’s because the drop in price is merely a technical financial process — meaning the public perception of the drop is not negative. And actually, the fact that a company has a strong enough P&L to provide a dividend, just instills even more confidence in the market about that company’s longevity. And therefore, this drop in price is typically seen as a good opportunity to get into the stock at a slight discount. And that’s why for strong reputable companies, this ex-dividend drop in share price usually recovers pretty quickly.
So then the next question you might ask is, “Ok, then why would anyone want to hold a non-dividend paying company stock?”
Well the classic argument, here, is that non-dividend yielding companies have a faster trajectory of growth because they reinvest all of their earnings back into their internal company growth initiatives. And this is a hard one to quantify exactly because depending on how the company uses these funds, if they are very efficient, their growth could be exponential, but if the company’s management isn’t that great — they could end up squandering these funds and probably would have been better off using that money to pay out a dividend to it’s shareholders.
So the short answer to the question, is that if you find a good company that knows how to re-invest their earnings appropriately, they could possibly grow the business substantially which would reflect more favorably in their stock price as opposed to a dividend yielding company, but that analysis has to be done on a case by case basis.
The personal approach I take is that I always optimize for growth of the company over whether or not they pay a dividend.
If I do my research and find a good company I believe in, if that company happens to pay a dividend, that’s a great bonus but I don’t make that a primary criteria when I’m choosing a stock. It’s not worth buying stock in a company that you don’t have full confidence in, just because they pay a large dividend. Remember — dividend payouts are not typically that massive, so at the end of the day, if the price of a stock doesn’t rise or even goes down, then that potential loss in share value would most likely outweigh any dividend pay out you might receive.
One last thing to recognize is that dividend payouts are not always guaranteed — a company may chose to decrease or even cancel their dividends if it becomes unsuitable for their business at a future time. For example — GE announced a little more than a year ago that they would be drastically cutting their dividends to investors.
So for me, given all of this, the fact that a stock pays a dividend is not usually a primary consideration factor, when I make my stock selections. But this is just my personal approach — you’ll want to follow whatever practice works for you.
And lastly, since this is a popular topic among all of the dividend content out there — let’s calculate exactly how much you would have to invest, in order to fully live off of your dividend income.
According to Zip Recruiter, in 2020, the national average salary in the US is $74k per year.
And as part of this exercise, let’s say we were 100% invested in a high dividend yield stock, like Home Depot — who offers a 3% yield, annually. So, doing simple math, in order to earn $74k in dividends per year, at a yield of 3%, you’d have to have $2.47M dollars invested in Home Depot stock. At the current price of $248.63 on June 2, 2020 — you’d be holding 9,921 shares of this stock.
And this is all assuming that the yield percentage stays the same in the future and that you don’t sell any of your shares throughout this whole period. So unless you have that much money in the bank, retiring off of dividend distributions may not come as easily as some of the content out there claims.
But in the course of your lifetime, if you’re very mindful and organized in how you manage your finances, by the time you retire, a $2.5M retirement portfolio may not be out of the question. In order to do that, you have to have steady income, strong financial management discipline and a good plan on how you’re going to get there. If you’d like to start with a good overview of the financial order of operations that’ll get you there — check out my previous article here.
In closing, Dividend Investing is like any other type of investing — it requires careful thought and enough research to know whether or not it’s truly the right strategy for you.
**** Disclaimer *****
The content here is strictly the opinion of Daniel’s Brew and is for entertainment purposes only. It should not be considered professional financial investment or career advice. Investing and career decisions are personal choices that each individual must make for themselves in accordance with their situation and long term plans. Daniel’s Brew will not be held liable for any outcome as a result of anyone following the opinions provided in this content.