A source of long-term stable passive income is something many investors look for in their portfolios. There are many strategies for long-term investment available and dividend investing is one of the most common and relatively simple ones to implement.
Many investors regard dividend investment as a retirement income stratetegy only, but in fact it can play a role as an income source in every portfolio. It also offers a benefit of passively generating income through a basic effect of compounding, allowing your portfolio to grow over time through reinvesting. How does this strategy work and how can you implement it on the eToro platform? Below is a quick guide that will help you to answer these questions.
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Contents
What is a dividend?
A dividend is part of profits the company generates and pays out to its shareholders; dividend payments are not mandatory for the company and are usually distributed as a ‘bonus’ every quarter. So one thing to note here is that dividends are not an obligation for the company but a choice entirely up to the board of directors, who may decide to increase, reduce or eliminate dividends at all. That is quite different to, for example, bonds, which promise a timely stream of cash flows in form of coupon payments. Dividends are paid out after the company uses its revenues to pay for all the costs, operating expenses and capital they used for investment.
Why do companies pay out dividends?
Why do companies decide to pay out dividends? Shouldn’t they just keep this cash to themselves? Many times firms pay out dividends to signal their financial strength and attract more investors, leading to an increase in the share price. More mature companies that don’t re-invest as much tend to pay out more dividends than younger companies which focus on using capital for development and expansion. In fact, some investors may see increase in dividends as a less optimistic prospect which implies that the company may be unable to find promising profitable investment opportunities to use its cash for, leading to stagnation or low growth. That is why it is important to analyze the company’s financial prospects as a whole and not only focus on the monetary amount of dividends it pays.
That is also the reason some companies choose not to pay dividends until they are very certain they can continue doing so sustainably. In case a company reduces or stops paying dividends at all (because it might be financially constrained or receiving lower revenues for some reason) that signals out negative prospects to the market and investors may sell their shares as a response.
The most common form of dividends is a certain cash amount paid per share, for example 20 cents per share. Dividends can also come in the form of stock dividends, so as a percentage increase in the number of stocks an investor holds. For example, if an investor holds 10 shares of a company and this company pays 10% dividend in form of stocks, then this investor will now hold 11 shares.
Preferred/ special dividends
Although dividends are not a company’s obligation, some shareholders have a priority in receving them. In fact, because the structure of shareholder ownership is hierarchical and some shareholders have a preferential claim on company’s assets in comparison to other common shareholders. So in case the company decides to reduce its dividends it will start doing so from the lower levels of the hierarchy – common shareholders, paying preferred shareholders first and only then the rest of investors, if anything is left. One of the most famous example of this is Facebook’s ‘dual class‘ share structure, where common investors holding type A shares have less privileges and voting rights then owners of type B stocks.
Sometimes a company may decide to pay a bonus to its investors in form of a special dividend in addition to the normal amount of dividend. For instance, if it had exceptionally profitable period it may decide to reward its investors with a one-time extra payment, usually in cash and that is called a special dividend.
Strategy
Hopefully the above introduction gave you a pretty good understanding of what dividends are, why and how they are paid, so we can get back to drawing up a strategy. Dividend investment strategy has a potential to become a source of stable, long-term passive income, providing you with a stable payment every month if you set it up in a correct way. Such an income should also not rely on surrounding market conditions as much but remember that any sort of investing involves the risk of not receiving the desired outcome and capital loss.
In simple terms, this strategy involves purchasing shares of companies that pay out a stable dividend income and keeping them for a long time period. Since different companies pay dividends at different times, and furthermore not even regularly, it may be usefull to draw up a schedule with expected payments to make sure the cash flows are relatively stable. Usually however, dividends are paid out quarterly, unless the board of directors decides otherwise.
So then there are two potential sources of income in your portfolio: a stream of cashflows from dividend payments as well as capital gains associated with possible share price increases. You can also grow your portfolio using this strategy by re-investing a certain portion of your dividend income into purchasing additional shares, which will then likewise pay dividend income. That compounds your income and allows it to increase exponentially over time.
Secondly, if you choose the companies well and they grow over the long term, their cashflows and hence dividend payouts would grow too. Dividend investment pretty much follows the snow-ball effect: larger amount of dividends you re-invest leads to your portfolio growing since more assets are purchased, and this larger number of asset will then lead to more dividends in the future and so on in the cycle.
So how should we go about setting up such a strategy? There are a few stept you might want to consider.
1. Deciding how much of your capital to invest
How much of your total portfolio you should dedicate to this dividend strategy depends on the degree on risk tolerance, your investing horizon and the amount of income you want to receive. Although this is considered a strategy for long-term stable income investment, do keep in mind it is not risk-free and that unlike bonds, dividend payments are not a guarantee of returns. Furthermore, because they are still just a type of an asset they are subjected to risks of financial markets like any other asset, including both company-specific and dangers from the overall market and economy. Another risk you should consider is the impact of interest rates. In case interest rates increase, investors may turn to ‘safer’ assets like bonds and that will cause dividend-paying stock prices to decrease given the fall in demand for them.
2. Selecting stocks
The next step is actually choosing the stocks to add into such a portfolio. Criteria for selecting companies for you passive income dividend strategy then could be a relatively good dividend yield, good financial indicators including low debt and stability of cash flows (i.e. income). Here are some of the most important ratios for you to consider:
1. Stable cash flow (income): what one might be looking for in a company is its ability to generate substantial and stable revenues and therefore profits, which they could then share with its investors. A popular metric that measures company’s ability to use its financial resources (equity invested in by the shareholders) to generate profits is Return on Equity or ROE.
Although that depends on the industry, in general a ROE over 15% is considered acceptable.
2. Reasonable debt levels: a company’s ability to repay its debt is one of the key indicator’s of its financial health. One of the most common ratios that measures that is the debt to equity ratio (D/E) which expresses a firm’s total debt as a percentage of its total capital provided by shareholders (i.e. shareholders’s equity). Any firm certainly requires debt for its operation, but that number should be below 2. Otherwise it is unlikely the company can repay its loans as it borrows two times more than it actually owns.
3. Dividend yield. And of course what we are actually looking for is how much of its profit the company shares with its investors and it is probably a good starting point in your process of selecting stocks. Every company pays different amounts of dividends, so the most common ratio used to compare dividends across companies relates dividends per share to its company’s share price. That basically shows how much cash the company pays each investor for holding its stock.
So for example a stock currently priced at $100 which pays out $5 has a dividend yield of 5% or 5 cents per each dollar you invested.
A dividend yield is sort of a return investors get from holding that company’s shares, and a yield of 1% to 3% should be reasonable, although that certainly depends on the industry. Does that mean that you should go for the stocks of companies with highest dividend yields? Not necessarily: one thing to understand here is that as the share price decreases dividend yield increases so investors that look at this ratio only might overlook the bigger picture. For instance, if the share price from the example above went down from $100 to $80 because the company wasn’t performing as well, the divident yield is now 6.25% but the actual value of shares you are holding decreased dramatically. Basically the dividend yield ratio grew at the expense of lower share value. What you might want however is both increase in the dividend income as well as in the principal value of your investment, which both constitute your total return. You can find information on dividend yield amongst all the statistics available on eToro.
In times when interest rates are low however high yields may in fact be very favorable. That is because although the share price might decrease, dividend payment may act as a compensation for a portfolio created to deliver stable income. Furthermore, if you use those dividends to purchase more shares you can now purchase more of them using these dividends (as each share not costs less).
4. Payout ratio. Payout ratio can be a good indication of how sustainable the dividends are as it expresses the amount of dividends paid out as a proportion of total earnings. Something to be cautious about here though, if the company’s payout ratio appears to be too high compared to the industry is it a good idea to question whether it will be able to sustain that level of dividends over time as well as continue to grow. A range of generally reasonable payout ratios is really quite wide, somewhere between 10% and up to 40%. Companies that payout more are perhaps struggling to find projects to invest into and that is not very promising for company’s growth.
5. Company’s financial statistics. Dividends are paid out from the company’s free cash flows (FCF), which are the operating cash flows left over after paying for capital expenditures. It is thus important to assess whether the company that’s paying dividends has enough cash to do so, as otherwise it would be redistributing money from borrowings or by depleting its assets, which is not possible to sustain in the long-term. You can see this information in the financial summary under the ‘Stats’ section, where both the income statement, balance sheet and cash flow statements for the 4 latest quarters are available. The cash flow statement should be helpful for you to understand how well the management of a company manages its cash flows to pay for current operating expenses as well as cover debt obligations.
The balance sheet should give you a pretty good idea on the amount of debt a company owns. Debt is not necessarily a bad thing of course, but you should beware that too much debt may be difficult for the company to repay so it can become insolvent, using all of its cash to repay loans rather than share with its investors, or even eventually go bankrupt. A balance should provide you with the information on the relative amount of debt a company owns and all the statistics to help assessing its solvency and liquidity.
It is also a good idea to consider stocks with a dividend that is not only sustainable but also has a growth potential; that will mean that your passive stream of income will grow not only as a result of accumulation but also because the company will increase its payouts to investors. Fundamental analysis and looking at the company’s growth potential within the industries it operates in may assist you in doing so. Assessing which companies have a dividend growth potential is not immediately obvious, but you may consider companies that have doubled the amount of dividends in the past decade, as it makes that an annual growth of about 7.8% on average in dividend payout. In fact you may consider an annual growth rate of up to 10% even. The pattern of how timely the company pays but also increases its dividends is also something to consider; dividend rise in 8 out of 10 latest years could be a pretty good sign of that.
It is also important to be aware of companies or even industried who’s revenues and profits are cyclical as they may not be able to pay dividends in a downturn; once again, looking at the dividend payout patter should give a good indication of that. The same concern applied to companies which embark on too much debt as that means that a big part of company’s cashflow goes back to creditors as mandatory interest and principal repayments. When a firm is not doing so well it may choose to forego shareholder payment not to default on its debt payments. You may want to consider diversifying not only in terms of companies but also in terms of market sectors.
Overall you may want to see an annual growth with a certain degree of certainty that it will be maintained. Typically companies that lead their industries or certain markets are considered to be the ones with the best growth potential. Such companies may also not be the fastest in terms of growth but do pocess the resources to sustainably raise their dividends over the upcoming years, with a history of good performance, promising business model and growth prospects. You may make a conclusion about those parameters based on the company’s statistics from the annual report which can be found under the ‘stats’ section.
Certainly combining all of these different statistics together may be overwhelming, so let’s consider an example. Let’s say you have identified two companies and need to choose between them:
| Statistic | Stock A | Stock B |
|---|---|---|
| Dividend Yield | 4% | 1% |
| Dividend Payout Ratio | 60% | 40% |
| Annual Dividend Growth | 5% | 13-18% |
| EPS growth | 7-9% | 10-20% |
There are a few things to notice here. Company B seems to grow fast and at an unstable rate, yet it increases its dividend payouts by almost the same amounts as its EPS growth, whereas A demonstrates greater stability, constantly increasing its divident payout by 5% every year. Now, if your are looking for growth in your strategy company B may be a more suitable choice, which is not necessarily intuitive as aggregate amount of dividens you’ll receive is likely to be larger than for Stock A, given that growth will be maintained in the long-run.
Diversification
Diversification is important in any long-term investment strategy and dividend investing is not an exception. It is not only different companies you might consider investing into, but also different sectors which are affected by major economic events in different ways.
Dividend Funds
Hand-picking individual dividend paying stocks for your portfolio is not the only way to construct it. Investing in mutual or exchange traded funds is an alternative, which offers diversification additionally not only in terms of assets but also industries. Certain ETFs prefer to choose companies with relatively stable dividend-paying policies. However, this means they may overlook more recent companies that haven’t been paying out for as long or focus their attention on certain low growth sectors. There are several ETFs focused on dividend paying stocks for you to choose from. Don’t forget considering ETF’s composition, its performance and any risks that might affect it before risking your capital.
Mutual funds are managed actively in contrast to exchange traded funds, meaning a team of professionals constantly monitors the market looking for a better selection of dividend-paying stocks. The downside of this is the fact that this active management is likely to increase expense ratio, coming both from the portfolio management fees and costs of operation.
Potential issues
Of course like anything involving the financial markets, there are risks associated with the dividend re-investment strategy too. There are still many ways in which it can go wrong, starting with the incorrect choice of companies that don’t deliver streams of dividend income you are relying on and onto focusing solely on the divident yield as the source of income.
Many companies change their divident paying patterns depending on the economic circumstances. For instance, firms tend to increase their cash holdings and decrease dividends paid out during times of economic downturns. For example, during the financial crisis of 2008,
Taxation
Dividends are of course as source of income and are therefore subject to taxation, depending on the regulations of your residential area. That is also the reason some companies choose to reinvest their profits rather than pay them out, as then investors benefit from capital gains caused by rising share prices and will only pay taxes if they decide to sell their stocks. There might be some exceptions however in case you are holding a tax-advantaged like individual retirement account which are taxed only upon money withdrawal.
Hopefully you now have a better idea of how to select stocks for your dividend portfolio, what kind of dangers to look out for and how to accomplish this strategy on the eToro platform. Beware of the capital loss risks and enjoy using the platform!
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