Have you ever asked yourself, “What is a dividend?” or “Can a dividend really help me reach my financial goals?” If so, you’ll want to listen to this! In this information-rich episode, Marc Bautis dives deep into everything you need to know when planning for your financial freedom — and how dividends may help you get there.
In this episode, you will learn:
- The definition of a dividend.
- Why it is important to look at a stock’s total return.
- What a payout ratio is and how it can benefit you.
- And so much more!
Tune in to learn about dividend-paying stocks and answer this question: “Can they help me get to where I want to go?”
Hello and welcome to the Agent of Wealth Podcast. Today we are talking about using dividends to achieve financial freedom. And boy that sounds fantastic. Marc how are you? I’m doing great. Aric, how are you? I’m doing very well. We’re talking about financial freedom and any time we can talk about financial freedom I think that that’s a positive thing.
Financial freedom is one of my favorite financial topics and dividends are up there as well.
What is a Dividend?
Let’s start with actually defining what a dividend is. The easiest way to do this is if we take a specific company as an example. We’ll use McDonald’s and throughout the year McDonald’s sells a lot of Big Macs that generate revenue for the company. They also have expenses producing and marketing these Big Macs. But at the end of the year, let’s assume the revenues exceeded the expenses and they have a profit.
They have a couple of options with what they could do with that profit.
- They can reinvest the profits back in the company. Maybe they want to open up new locations or they want to do research and development to create a new burger.
- They can use it to acquire another company. Let’s say there is a different business line that McDonald’s wants to get in. They don’t want to do it themselves so they just go in and purchase a company.
- They can keep the profits as cash on their books and use it however they want to in the future.
- They can buy back their shares. Let’s say there are a million shares of McDonald’s outstanding. McDonalds can go out there and use that profit to buy a portion of the shares back. Usually the most common reason for doing that is it will give a quick short term boost to the stock price.
- But what we’re going to talk about today is how the company can pay that profit back to the shareholders as what’s called a cash dividend. The company can declare a dividend and send money back to the investor. The investor can then do whatever they want with the money. Dividends are usually paid out quarterly.
Why would the company pay a dividend? Obviously they’re giving cash back to the investor. Why would they do that instead of using that profit as cash reserves or doing something to reinvest like maybe double the size of the McRib. It’s just a dream of mine.
The company is going to look at where the best use of the money is. It may be like you said, improving the McRib, or they may want to reward the shareholders by paying a dividend. It also incentivizes the shareholders to to either stay or stick with McDonald’s loyalty and hold their shares or buy more shares.
Instead of the dividend check coming to me can you just assign me how many shares that dividend can buy.
Exactly and that’s what we are going to talk about as one of the benefits of dividend paying stocks.
Benefits of Dividend Paying Stocks
Once the company declares and pays a dividend, the shareholders are free to do whatever they want with it.
- They can reinvest it and buy more shares of the stock that paid the dividend.
- They can use it to buy more shares of another stock
- They can take that cash and use it to pay for their living expenses.
That’s one of the reasons why dividends are very popular. I call them the Swiss army knife of investing tools because they can really solve a lot of problems. They are great for most people. I’ve seen investors have a child and they start buying dividend paying stocks on that child’s behalf. It can be a great tool for someone who is young. It is also great for someone on the other side of the spectrum who is retired and wants predictable income to pay for their expenses. A lot of times you think of bonds for fixed income, but dividends can also play that role as well.
You said predictable. You gave the example of somebody in retirement. They want a predictable stock that’s going to be paying them dividends, but it doesn’t mean that they’re always going to get dividends. What if the company doesn’t make the profit that they thought they were going to and how predictable really is it?
I think what you see is that dividends are a lot more predictable than you would think. Even though that company always has the choice of what to do with that profit, but once a company declares a dividend they usually hold that dividend sacred. They do anything they can to not cut that dividend or not to pay out that dividend. Over time they want to try to increase that dividend because it gets them into different classifications of dividend paying stocks. That’s really appealing and people really like to, to invest in those specific companies. Yes, the dividend is not guaranteed, but the company does whatever it can to, to make sure that they do make that payment.
It is all about that loyalty and that excitement as they are able to pay out more. More people are going to be paying attention and loyal to that company seeing that they are making that effort which raises them up into that stratosphere of a dividend paying stock. How do they get that rating?
I wouldn’t say it’s a rating but I’m definitely seeing there is more awareness within the investing public to dividend paying stocks and there are a lot of different reasons why people are asking me about them.
There are different ways to filter out dividends that fall under this category and we’ll go into how you can select dividend paying stocks. You are getting that cash payment which you’re free to use but also they are a stock. So over time theoretically the price of the stock should appreciate as well. You are getting growth along with that cash flow piece.
Dividend paying stocks usually fall under some of the more market resilient industries that are out there. A lot of utilities are dividend paying stocks so even if the market takes a downturn you are still going to heat your house, you are still going to want the electricity on. Health Care and Consumer Staples are two other industries that are known to pay dividends. You don’t want to use the word safer but the dividend payers usually see less volatility with their stock price.
Absolutely. What are some other benefits?
They usually are good for both retirement and taxable accounts. Good for retirement accounts in that in a retirement account like an IRA or 401K you get to defer paying tax on any of the gains, interest, or dividends that the investments generate. In a taxable account qualified dividends are taxed at a rate of 15 to 20 percent depending upon what your income is. That is usually a lot better than if you’re taxed on interest on a bond or a CD which is usually is taxed at your ordinary income rate and can be as high as 37%.
I equate dividend paying stocks to rental real estate property which we talked about on Episode 20. In rental real estate property you have your tenant paying their rent assuming that the rents cover all of the expenses you’ll have positive net income each month similar to a dividend. You can also expect the value of the house to appreciate over time. With dividend stocks you get the dividend cash payment, but also you get the best of both worlds where you usually see some growth with the stock price as well.
Marc that sounds great. All those things sound like positives. Are there any mistakes investors make when it comes to trying to pick dividend paying stocks.
Don’t Reach for Yield
There is one big mistake that I see all the time and it’s when investors reach for yield. Here is how you can calculate the dividend yield of a stock.. Let’s assume that a particular stock trades at $10/share it pays a 50 cent dividend for the year. If you divide the dividend payment by the share price it comes out with a yield of 5%. We previously talked about how investors will filter dividend paying stocks and one of the things they filter on is yield to see who is paying the highest dividend. Would you rather have a stock that pays a 10 percent dividend or a 3 percent dividend?
I’m going with 10 percent.
Most choose 10%, but it’s sort of a “gotcha” question because the dividend yield is not the only piece of the stock that you should evaluate when determining what to invest in. There is danger in taking this approach because what happens a lot of times is that yield will get really high because the stock price is dropping. If the stock price goes down that year it has an inverse relationship with the yield and the yield goes up.
If we use the example we just talked about with 10 dollars a share and we’ll just keep it simple and use that they pay a dollar per dividend yield is 10 percent. Now if the stock price drops to five dollars a share and they’re still paying that dollar dividend. Now it’s showing that the dividend yield is 20% and you might think this is great. I can get a stock that’s paying a 20% dividend but you didn’t realize you just lost 50 percent because the stock price was halved.
When evaluating a stock you want to consider the stocks total return. That includes the stock price which may be increasing or decreasing. There usually is a reason if the stock price is decreasing and may make it more of a risk. A decreasing stock price makes the dividend yield look higher. While a higher yield is more appealing, it may mean there is more of a risk.
How do you how do you navigate that minefield out there?
There are a couple of different ways. One of them is to look for dividend paying stocks that have increased their dividends over time. Let’s say this year a company’s dividend payout is $1 per share to $1.10. And to $1.20 the following year. I don’t really care how high the raises are each year, just that they are consistently raising the dividend payout. Obviously the higher that they’re raising it each year the better. But I just want to see them make that commitment to increasing it every year. The data is available where you can research these companies and you can find companies that have been increasing their dividends for 30, 40, and 50 years straight.
If a company can continually raise their dividend even when the market or economy is bad it goes a long way to exhibit their strength.
How could they possibly do that if their stock is going down?
Payout Ratio
Stock prices will go up and down. Hopefully they trend up over a longer period of time. They have to be a well managed company. A company can’t pay dividends if it doesn’t have cash to do so. They can’t just pull money out of the air to pay their dividends. They actually have to have profits to be able to make that dividend payment. You want to look at a company’s payout ratio. This is a number that tells you how much of the company’s profit did they pay out as a dividend to their shareholders. The payout ratio is a percentage and the lower that percentage is the better.
So let’s look at a simple simple example on how to calculate the payout ratio. Let’s say a company has a profit of $2 a share for the year and pays out a total dividend for the year of $1 per share. We can calculate the payout ratio as $1 / $2 = 50%. That means that the company’s payout ratio is 50 percent. They are taking half of their profit and paying it out as a dividend. If the company’s payout ratio is lower that means they are keeping more cash in the company. If they paid out every cent of profit as a dividend it would make the investors feel great but it also increases the risk that if they have a bad quarter or year they are not going to have a buffer (or rainy day fund) and will have to cut the dividend.
Anything above that could be a danger that at some point they cut or eliminate their dividend.
Another tool you can use is to check the total return for the stock. Is the stock price growing? Is the is the dividend a reasonable dividend rate. Is it extremely high? Usually if it’s extremely high that’s a red flag to look into. You also want to search for companies that have increased their dividend each year over the past 10, 15, 20 years.
Those are three criteria that I use to select to construct a portfolio of dividend paying stocks.
3 Pieces of Criteria for Selecting Dividend-Paying Stocks
- The payout ratio less than 60%.
- The total return of the stock.
- The dividend has been raised consistently.
For the average listener like me I can’t do all that. It’s overwhelming to take all of those things into account. You explained it very well, but I’m assuming you do this for clients upon request.
There are really a couple of ways that someone can go about you building a portfolio of dividend payers.
You can take the three criteria that I just gave and someone can go and do it themselves. They can analyze the data and filter out stocks to put together a portfolio together.
The second option is they can they can have someone like myself do that. I have access to data and access to tools and technology that can screen company’s and funds that fit a certain criteria.
The third way is to use exchange traded funds or ETFs that can fit some of these profiles as well. You might say I only want companies that have increased their dividends for the past 25 years and there’s probably a fund for that.
And if you want to invest only in companies that have a payout ratio less than 50 percent you can probably find a fund for for that too. If you want a diversified portfolio you may not just want large cap companies and add small cap or mid cap companies that pay dividends too. There are international companies that pay dividends and you can use that same approach when adding them to the portfolio.
We then want to discuss how can we use these dividends to build up that passive income number and ultimately get to achieving financial freedom.
3 Steps to Using Dividends to Achieve Financial Freedom
Step #1
First, get started by adding dividend paying stocks to the portfolio. We are start from a clean slate of having $0 per month coming from dividends
Step #2
Try and automate your purchases of dividend paying stocks. I usually see the people that have the most success with building these portfolios and accumulating dividend income is to automate your savings. Automate some money that goes into there each month just as you do to your 401k or retirement plan.
Step #3
Reinvest the dividends that you start receiving. If you don’t need the dividend cash to pay for living expenses it makes sense to reinvest the dividend and purchase more shares of the company. This accelerates and compounds your growth and income.
Let’s say that you have 100 shares of McDonald’s and McDonald’s is paying you a dividend each year. You can take that dividend and do whatever you want with it. If you reinvest that dividend each time you receive it and increase the number of shares of McDonald’s that you have. After McDonalds pays you a dividend and you reinvest it you would go from owning 100 shares to 105 shares. The next time a dividend is paid you’re getting paid a dividend on 105 shares. Now you take that dividend and reinvest it and buy more shares of McDonald’s. Now you have 110 shares. On the next dividend you’re getting a dividend on 110 shares. If you keep doing that over time that is how you amass wealth and really build up that passive income stream.
Can that be automated also?
Of course. Yeah. Oh that’s great. Other piece of it is automate that as well. Same Same drill. You don’t. You know you set it up you don’t have to go in and and you know manually allocate that dividend that comes in.
And when I say reinvest the dividend, you actually don’t have to invest it in the stock that the dividend came from. Some people will actually take the dividend from one stock and use it to build up a position in another stock. You can take that McDonald’s dividend and use it to buy up to buy shares of Apple. It’s just a natural way of diversifying a little bit instead of having that concentrated position in McDonald’s. Obviously I’m just using McDonald’s as an example here.
Gotcha. We’re not endorsing the McRib, although it is very tasty. What else do we have to cover with dividends.
Track Your Progress
The last piece that I would suggest and this goes for any type of goal is to track progress on it, even if it is small progress over time. One way to do is to tally up the monthly dividends you are receiving over time. When you start out your monthly dividends are $0. After you buy one stock, you may not be receiving $10 a month in dividends. And you start automating your savings and reinvesting the dividends and pretty quickly that can grow to $100 per month. And if you continue to do that monthly later it can get up to $1000 per month. And then if you continue to be disciplined and save you can get into the $10,000+ per month of passive income
Tracking it helps because as an investor it helps you keep pushing towards the goal as you see improvements getting you towards that financial freedom number.
It really becomes a very rewarding experience being able to see that because whether we see the money going in or not it’s still in our brain registers as a “sacrifice”. I’m sacrificing something else to make sure that I achieve financial freedom or a secure retirement. Being able to have that backed up by seeing the progress.
Exactly. And I am a big proponent of visualization. As you see your monthly dividends growing it goes a long way to pushing you. People usually track it manually using a spreadsheet by putting the months across the top and your dividend paying stocks/funds across the left column. And fill it out by putting in what each pays per month.
I have a tool that will generate a report that shows how much income all of these investments are generating and it automatically produces an output similar to the spreadsheet that we just talked about. This is something that I review with with clients and we track the progress of it.
I’ve had clients that are on all levels of working towards financial freedom. Some are just starting out and some are over $20,000 a month in passive income. It doesn’t happen overnight. It takes discipline, it takes time, and it takes a strategy but it’s definitely something that can be done.
That sounds fantastic because I don’t want to do it all myself. I don’t want to input all of the numbers. I’d love to be able to talk to somebody quarterly or annually and have them produce that report that shows you know how it is doing.
It also provides peace of mind for retirees because if they see a report that shows the dividends that these investments are producing. Those dividends may be enough to cover their all of their expenses and they may not have to ever touch my principal and deplete their assets.
We are running low on time. Do you have any closing thoughts for today?
I just want to say that dividends paying stocks a great tool. They are still stocks so they may not be right for everyone. They could be volatile. As far as investing tools they solve a lot of different problems when it comes to someone’s finances and should be something that is at least considered.
If you are interested in learning more, please reach out to Marc for a complimentary consultation.
Episode 22 – What Would You Do If There Was A Recession?