Best Dividend Paying Stocks – Part-1

Are you interested in investing in the best dividend paying stocks?  Selecting the best stocks with good dividends can be very tricky.  This is especially true if you’re new to investing.  If you’re looking to better understand what dividends are and how you can pick the best dividend paying stocks, then look no further!

In Part-1 of this series, I explain exactly what dividends are and where they come from.

First Things First

If you are new to investing I suggest you read this post first.

It is always a good idea to have a core portion of your stock investments in market index funds.  It is generally a bad idea to just go out and pick a couple random dividend paying stocks for your portfolio because issues such as diversification and risk are difficult to address with only a handful of stocks.

I hear you saying now – “Derek, investing in market index funds is so boring.  How can I inject some excitement into investing?”   For those of us with extra time looking to spice things up a bit, this series will teach you how to identify the best dividend paying stocks for your portfolio.  Most experts recommend that you allocate no more than 5% – 10% of your total portfolio to a basket of individual stocks that you will pick yourself.  I think this is a great rule of thumb.  It allows you to have fun trying to find those diamonds in the rough without putting your investment portfolio at serious risk.  If one or two of your stocks suffered a major decline and made up 50% of your portfolio, it would be very difficult to recover financially.

 

What Exactly is a Dividend?

Now you may be asking – what exactly is a dividend?  Wikipedia tells us that a dividend is: “a payment made by a corporation to its shareholders, usually as a distribution of profits.”  These payments are usually made on a fixed schedule (monthly, quarterly, annually) or on a special basis at any time as approved by the corporation’s Board of Directors.

Dividend payments are calculated by multiplying the dividend payment per share times the number of shares that you own.  The payment is normally disbursed in the form of cash directly deposited to your investing account.  The company could also elect to pay shareholders with additional shares if they do not have cash on-hand.  As an example, If you own 100 shares of Pepsi stock and a $0.57 dividend is declared for the quarter, you will have $57 deposited to your investing account.

 

Where do Dividends Come From?

A company generates revenue by selling a product or service for money.  After expenses, salaries, loan payments, taxes, etc. are deducted from this revenue, the company is left with what we call net income (or income minus all expenses).

Here is an easy example to illustrate net income if you’re confused – The below made up numbers are for the Widget Company for the 2012 calender year.  All figures are in millions of dollars:

Net Sales

• Widget Sales: $100

Expenses

• Cost of widgets: $40
• Salaries: $10
• Depreciation on Widget machine: $5
• Loan interest paid to bank for Widget machine: $4
• Taxes: $15
• TOTAL EXPENSES = $74

Net Income

• Net Income = Income – Expenses = $100 – $74 = $26

Now, what’s the Widget company to do with this net income of $26 million dollars for 2012?  There are three things that the Widget Company can do with this money:

1. It can keep the money and re-invest it in the business.  This is called retained earnings.
2. It can repurchase some of its outstanding stock.  This is called a share repurchase or share buyback.  Because this reduces the number of shares outstanding, it will boost the earnings per share and cause the stock share price to increase.
3. It can payout a dividend to current shareholders.

 

Can a Company Pay a Dividend If It Lost Money for the Quarter?

Sure it can!  As long as the company has enough cash on hand to cover the dividend payment, the company is free to declare and pay a dividend.  If a company has had a rough quarter and actually lost money, it can dip into its retained earnings (cash) to cover future dividend payments.  Companies will quite often do this versus canceling the dividend as this would cause many investors to sell their stock.

 

Best Dividend Paying Stocks – Part-1 – Final Thoughts

In Part-1 of this series, we’ve covered the basics of dividends.  You’ve learned what a dividend is and where it comes from.

We’ll build on the knowledge you’ve gained here in future parts of this series.  Part-2 will discuss why finding and investing in the best dividend paying stocks can be a really important part of your long-term investing strategy.

Checkout Part-2 here!