Stock Dividend: A Beginners Guide to Stock Dividends
What is are stock dividends?
A company makes these payments to its shareholders. They are usually paid after a company makes a profit. The payments are in shares rather than cash, which enables the company to stay afloat even after a huge payout. However, not all stocks pay dividends.
Companies make these payments in form of a percentage of what the shares each shareholder has. For example, if a company decides to issue a 5% stock dividend, and you have 1000 shares, you would receive 50 more shares.
Some companies pay in cash, especially on annual basis. For example, if you have 100 shares in company X that pays a $2 cash dividend per year, you’ll receive $200.
How does a stock dividend work?
Stock dividends are awarded to shareholders instead of cash dividends. As such, investors receive shares rather than cash. Companies result in stock dividends when they want to use cash for other investment needs. The best part, you are not taxed until you opt to sell them for cash.
Companies can also issue stock dividends if they want to increase shares of their stock or when they want to minimize the distribution of cash to their shareholders.
Investors and analysts use dividend ratios to forecast the dividends companies might payout in the future. Dividend payouts are affected by several factors such as debt load, earnings, dividend payout history, and others.
Companies in the growth stage usually pay stock dividends while behemoth companies are more likely to pay cash dividends. Some of the popular dividend ratios are dividend coverage, dividend payout ratio, Net Debt to EBITDA, and dividend payout ratio.
Dividend payout ratio
This is the most common financial ratio that investors and analysts use. It measures how much of the company’s earnings go to paying dividends. It is as easy as dividing the amount of dividend it paid against its earnings at that time. This ratio shows how a company’s dividend is safe. It also signals its future growth.
If a company has a high payout ratio, say 70%, investors and analysts term it unhealthy. This is because the company is using a majority of its earnings to pay dividends. As such, it may run into debt when trying to keep the business afloat.
That said, you can invest in a high dividend company if its earnings are steady and growing. Generally, a payout ratio below 60% is a perfect bet.
Free cash flow
Well, without the flow of free cash, a company might fall into debt and become bankrupt. To calculate a company’s free cash flow, you need to subtract its capital expenditure from its cash flow. This shows whether a company is using much of its money to pay bills or not.
If there’s no cash flow, then the company cannot pay the stock dividend, support its operations, or payout its outstanding debts. Such companies tend to have capital-intensive projects but with little ROI. As a rule of thumb, invest in a company with healthy free cash flow.
Return on invested capital
Return on invested capital is yet another dividend ratio most investors consider. If company A can turn your $500 into $700 while company B can turn it to $800, which one would you choose? You’d pick B, right? This is what investors consider when choosing which dividend stocks to invest in.
If a company can generate higher returns, then it can compound capital faster. Avoid companies that do not perform as per your expectations. That is, their return on invested capital is low. Besides, such companies tend to have a competitive edge compared to their peers.
Operating profit margin
This dividend ratio divides a company’s operating profit with its total sales. These profits are devoid of taxes and interests. As such, investors and analysts can see how a company is profitable in its daily activities. Companies with high operating profit margins tend to be doing better economically.
That said, investors also look at a company’s operating profit margin history. If there’s no consistency, then they do not invest in it. They’ll go for companies with consistent operating profit margins. Besides, it shows it can compound earnings seamlessly.
This is yet another financial ratio used by investors. However, it is less common compared to others on this list. While overlooked, it is an important ratio since it shows the efficiency of a company. To get a company’s asset turnover, you divide its sales by its assets. It shows how much sales each asset generated.
As expected, companies with a higher asset turnover will have higher profits. In fact, some companies might have a low operating profit margin but have healthy asset turnover. This shows it can pay its investors dividends within the specified time. It is also an indication that a company is using its assets profitably.
To get a company’s sales growth, you’ll subtract previous revenue from the current revenue and express it as a percentage of the previous period. For example, if a company has $150 sales this year up from $100 last year, its sales growth would be 50%.
Sales growth signals a company’s potential to expand and the volatility of its business model. Companies with higher sales growth tend to outshine their competitors and register higher profits. It is also crucial for an investor to consider the sales growth history of a company. This data can show how consistent a company’s revenue is.
Just like we sometimes survive on borrowed money, the same is true for companies. The Net Debt-to Capital financial ratio shows how much debt a company is using to run its operations. Most companies will use debt and equity to fund operations or purchase equipment.
It is hard to tell how much of the two is invested. But thanks to this financial ratio, it is easy to tell what proportion of a company’s operations is running on debt. It is advisable to invest in companies with a net debt-to-capital ratio lower than 50%.
Net Debt/ EBITDA
This dividend ratio shows a company’s debt in relation to its earnings. It shows that while some companies might be in debt, investing in them might not be risky. Particularly those companies with cash at hand and generating enormous profits. For example, if a company has a $1000 debt and $500 cash on hand, its net debt is $500.
EBITDA short form for earnings before interest, taxes, depreciation, and amortization shows a company’s cash flow without including its expenditures. EBITDA is mostly measured on an annual basis. Companies with a net debt/EBITDA of less than 3.0 are ideal to invest in.
This is a popular financial ratio among avid investors. It takes a company’s stock price and divides it by earnings per share generated over one year. Top-performing companies tend to have an average price-to-earnings ratio of about 15. It is therefore advisable to invest in companies with a P/E ratio of less than 20.
Total Shareholder return
This financial ratio measures the increase in a stock’s price with the inclusion of its dividends. Well-performing companies will have a healthy TSR over time giving investors value for their money invested.
Having a basic understanding of the above dividend ratios can help you make informed investment decisions.
Best dividend stocks to buy
Microsoft is one of the largest tech companies in the world. Providing computation solutions, the company has seen steady growth in its sales volume. The company has a steady free cash flow and minimal debt. Besides, its payout ratio is low leaving room for exponential growth.
Version is wireless communications and a high-speed internet provider. The company is a favorite for many investors since it has minimal debt compared to its competitors. Besides, it is involved in an industry that is poised to grow. With the exponential growth of 5G connectivity, the company is set to take a big share of the market.
Apple is yet another company you should consider investing in. an industry disruptor, it comes up with products that set the pace. While its dividend payment dates a few years ago, it is still a company to consider. The best part, it has a loyal following across the globe thanks to its high-tech products.
Investing in stock dividends is ideal especially if you are looking for long-term investment. They attract no taxes and can grow exponentially if you invest in a well-performing company. Be sure to understand a few dividend ratios so as to invest in the most appropriate stock dividend.