Simply put, dividends are the primary method by which a publicly traded company returns profits to shareholders.
Are you ready to understand “What is a good dividend?” to put it simply? You may also want to simplify your knowledge of what dividends are and why you might want to buy one.
In this article we go into deep detail on what makes a good dividend yield, how to calculate dividend yield, what “high” and “low” dividend yield is and what it means. Let’s dive in.
What is dividend?
The dividend yield refers to how much money a stock pays when you own it. Dividends are money a company pays to investors, usually from earnings (but not always). They are a fundamental reason for owning shares and one of the reasons why the stock market exists. Investments pay you to own them, either through capital gains or profits. Dividends show how a company in today’s stock market pays profits to shareholders.
What is a good dividend for a portfolio? Naturally, that is a more difficult question to answer.
What is a good dividend?
What is a good dividend? That’s a loaded question.
What is good for one company may not be good for another and also not good for your portfolio. A good rate of return is one that a company can maintain when they pay it. A regularly paid dividend is the basis of a buy-and-hold mentality and something most companies hope for and strive to achieve.
For easy reference, a good return should be high relative to the broad market S&P 500 and the company’s peers. Ironically, you don’t even have to own shares for more than a day to get the dividend. To find out how, you need to know about the ex-date versus the record date.
How is dividend calculated?
The dividend yield is a simple calculation. You determine the yield by dividing the dividend amount by the share price. There are two ways to calculate returns: You can use the dividend payments over the trailing twelve month period (TTM) and you can also use the expected dividend payments over the coming twelve month period.
Why is dividend yield useful?
The dividend yield is useful because it is one of only two reasons to own a stock – growth and dividends:
- Growth: The company is growing and the stock will be worth more in the future.
- Dividend: The company shares the profits in the form of dividends. Dividends are also useful as a means of generating income, leverage your portfolio by investing in dividends, and they can help offset inflationary declines.
What is a good annual dividend? One that makes you smile when you think about it. One way to find them is to use the best tool for dividend stocks.
When is a dividend too low?
When is the dividend yield too low? You have to answer that question yourself.
Some of the reasons it may be too low could be due to your portfolio strategy, the return relative to peers, the return relative to the S&P 500, and the risk associated with owning bonds. If the objective of the portfolio is low risk and you want to achieve income without the need for capital gains, your threshold may be lower than if the portfolio was more risk tolerant and if you were looking for growth.
In any case, consider owning a number of dividend stocks for diversification and security.
When is a dividend too high?
At face value, no dividend yield is too high because higher is better as long as it is sustainable. In reality, dividends must be sustainable to be attractive to investors. Unfortunately, high yields are not always sustainable.
A dividend is too high when the company cannot maintain the payout. If there is a risk of a dividend cut or suspension, which could weigh on the share price and even worse, it could lead to a loss of capital if the cut or suspension occurs.
What is a good dividend? In this case, it’s a dividend you can count on.
What causes a high yield?
There are many reasons that can affect the return dividend shares, including the payout amount and the price action. Let’s look at some reasons in more depth:
- A stock’s dividend yield is a function of the payout. Assuming the share price remains static, the higher the payment, the higher the return. The problem (or opportunity) for investors and traders, depending on how you look at it, is that a stock’s price is rarely static.
- A stock’s dividend yield is also a function of its price action. Assuming that the dividend amount remains static, which is so often the case, an upward movement in the share price will reduce the yield. The opposite of this is true if the share price moves lower. If so, the yield would move higher and open up a potentially high return opportunity for investors.
- A stock’s dividend yield is also a function of data. Sometimes the data used to determine the returns shown are based on past performance and not relevant to the future. An example is an MLP, REIT, or freight stock that pays its monthly payment based on income. In some cases, traditional companies are governed by managed distribution plans that dictate how much, how often and when a dividend payment can be paid. For example, the company Cal-Maine Foods (NASDAQ: CALM) cannot make a distribution for any quarter with negative earnings, and the company cannot make a distribution until lost earnings have been taken up.
- News can have a big impact on the yield. For example, news appearing on websites and in stock searches can send a stock price into the dustbin and trigger a massive increase in returns. The problem with this type of “high yield” is that the news may have already included a dividend cut or suspension or may lead to one in the future.
Evaluating high returns for risk
High dividends are attractive to investors because more is better, right? When it comes to dividends, high payouts can be a red flag or, in some cases, an indication of problems that have already occurred. Check out a list of things to consider to know if a stock’s high yield is worth buying or not.
Compare the return with peers
Dividend-paying stocks in the same sector tend to pay out similar returns relative to their values. The first thing to check when considering a high return is to see if it is abnormally high for the group. A higher than average return is one thing – it can signal an opportunity. However, a significantly higher yield is reason enough to dig deeper into the details.
You get what you pay for. What you don’t want to pay for is a distribution cut or suspension that will leave stock prices in the dust.
Check out dividend statistics
Most stock websites will publish a list of frequently followed dividend statistics that you can use to weed out risky high-yielding stocks. Among these metrics are the payout ratio, the compound annual growth rate (CAGR) and the years of consecutive increases.
The payout ratio tells you how much of a company’s earnings is paid out in dividends. In this case, lower is better and higher is worse. The higher the payout ratio, the less room in the cash flow for dividend increases or payment for other things such as growth.
The next statistic is CAGR, which tells you the rate of distribution increase which may be more important than dividends. The higher the CAGR, the better, because it means that the return on investment continues to grow and should grow at the same rate in the future.
The final statistic is the number of years of increases. This number can tell you a lot because a history of consistent dividend increases can be a powerful reason to buy and hold a stock. The top dividend stocks has a decades-long history of dividend increases.
Check the balance
It doesn’t take an accountant to see red flags on a balance sheet. The simple numbers to look for include cash and equivalents (known as liquidity) and the company’s debt, both short and long term. If the company has a healthy cash balance and little or no debt, the cash flow is unencumbered by debt payments and free to use.
If not, the company may have a hard time paying dividends or maintaining its record of consecutive annual increases. You can check the leverage ratio, a measure of how much debt the company has in relation to its assets. In this case, low is good. A leverage ratio below three is very good; under 10 is fine depending on the reason the debt exists.
Learn what others are saying about the stock
Finally, what are others saying about the stock? Check analyst ratings and the trend in analyst sentiment. If the analysts heat up and this matches the fundamental outlook, the high-yielding dividend stock is likely a good buy. If analyst sentiment cools, you may want to avoid it. After that, check the headlines and find out if the company is struggling in any way or facing obstacles that could affect its results.
A good dividend is where you find it
So, what is a good dividend? Simply put, it is one the business can maintain and that fits the needs of the portfolio.
You will appreciate a good dividend, but good is relative. A good return for a tech stock can be a terrible return for a consumer trust case – not all types of companies can sustain a “high return”. To find a good rate of return, make sure the company can pay it and compare it to others in the sector. If it looks attractive compared to its peers, then it is a good dividend.
Do you still have questions about what makes a good dividend? There is no single answer to rule them all. However, we will dive into some common questions to help you understand which dividend yields are good and which ones to avoid.
Is a 6% dividend good?
A dividend of 6% is good. That’s more than three times what the average S&P 500 company pays and well above the threshold to be considered a “high yield.”
What is too high a dividend?
A dividend yield that is too high refers to one that is not sustainable. A 10% return coming from a highly leveraged growth stock is not the same as if it were paid by a REIT. To get an understanding of an excessive dividend yield, compare returns within sectors and check out earnings, free cash flow and balance sheet to see if the company has the money.
What is a good average dividend?
A good average dividend yield depends on the sector and the share. Each sector tends to trade at a different value and they vary over time. To find “average” dividend yield, compare returns within a sector and with the broad market S&P 500.