Would you be interested in getting paid to invest in the stock market? Who wouldn’t? While it might sound far-fetched or even a scam, the reality is that you can get paid to invest in the stock market. In fact, you are probably getting paid and don’t even realize it. The way you get paid to invest is through earning dividends and this post is going to show you all you need to know about the power of dividend income.
What Is A Dividend?
In order to show you the power of dividend income, we first have to make sure that we all understand what a dividend is. A dividend is simply a payment that a company makes to its shareholders from the net income it makes in a given year.
For example, let’s say I run a company and you are an investor. My company makes $100 this year in net income. I decide to pay out $1 of the profits to each of my shareholders. When this happens, I give you $1 of my earnings. This is what a dividend is.
It’s important to understand that not all companies pay a dividend. Also of note is that each company decides how much to pay out each year in total and they can increase or even decrease that amount when they see fit.
Each company also decides how frequently to pay a dividend. The majority pay quarterly or 4 times a year. Some pay monthly, others semi-annually and still others pay annually. Some companies that don’t pay a dividend can even make a one-time special dividend payment to shareholders. To get an idea of how frequently a company you are considering investing in pays a dividend, check out this great resource.
So to recap:
- Not all companies pay dividends
- Each company decides how much to pay
- Each company decides how frequently to pay the dividend
The Power of Dividend Income
Now we get to the good stuff – the power of dividend income. There are 2 reasons why dividends are so powerful. Let’s assume that I own 10 shares in a company that pays out a $0.10 dividend per share once a year. When the dividend gets paid, I receive $1 (10 shares x $0.10 dividend per share = $1 dividend income).
What I do with this dollar is completely up to me. But at the end of the day I have two choices:
- I can take the cash
- I can reinvest the dividend
If I take the cash, I can spend it as I please. It is considered additional income (called passive income by many people) to me. As long as the company pays out this dividend, I will continue to get $1 every year.
If on the other hand I reinvest the dividend, the magic starts. Let’s assume the stock trades at $10 per share and I reinvest my $1 of dividend income to buy more shares. I started with 10 shares but after the dividend in the first year, I now have 10.1 shares.
To keep things simple, let’s just assume the stock price stays at $10 and I get the same $0.10 dividend per share each year. How many shares do I have at the end of 20 years?
I end up with 12.2019 shares after 20 years. Understand that I never invested any more of my own money. I used the dividend to buy more shares. The exciting part though is the dividend I earned. At first I was earning just $1 but because I bought more shares each year, the amount of my dividend increased. At the end of 20 years, I earn a total of $22.02 in dividends.
Notice that when I took the cash, after 20 years, I would have made $20 in dividends ($1 each year for 20 years). But since I reinvested the dividend and bought more share, I earned a slightly larger dividend each year. This is shown in the chart below.
This is the power of dividend income when you reinvest them. They allow you to buy more shares without putting any money from your pocket into the stock and that allows you to keep collecting larger dividends. Of course in the real world, companies increase their dividends and you can invest more of your own money to really make the growth rate speed up. I know that the numbers above are small and might not seem very exciting or appealing. But, I wanted to keep things simple so you could follow along.
One last example to hammer the point home. We are going to look at 3 stocks that paid nice dividends from 1980 through 1998 and their annual returns. You will see from the chart below that they had decent gains just from stock price appreciation. But, on the right you see how much larger the return was when dividends were reinvested. On average, they earned an additional 3-5%!
And this isn’t just with these 3 stocks either. Historically, from 1930 through 2012, dividends account for over 40% of your annual returns.
Using The Power of Dividend Income Yourself
Before you run out there are start investing in dividend paying stocks, I have a word of caution for you. I already know what you are thinking: if you can find the stocks that pay the highest amount every quarter, you will be getting boatloads of dividend income!
This is exactly how NOT to use the power of dividend income. You will get burned if you go this route. Why? For two reasons:
- First, if you only focus on the yield, you are missing important information. A yield increases as the dividend increases, but it also rises as the stock price drops. Therefore, a low priced stock can appear to have a great dividend when in reality it doesn’t. The lower stock price could even mean the company is in trouble.
- Second, remember that companies can cut a dividend at any time. If you see a company paying a hefty dividend and the industry it is in has tight margins, you might want to do some more research. If a company cuts its dividend you can expect the stock price to drop as many investors who own simply for the dividend will flee. With less demand for the stock, the price will drop.
So how do you do about using the power of dividend income to your advantage while limiting the chances of not getting burnt? The answer is to research and invest in high quality companies. There are many companies who have pay dividends every year for the past 25 years. With that said, there are many good companies to invest in for their dividends.
I reached out to some of the brightest dividend investing bloggers out there and here are their favorite dividend paying stocks and why. (Note these are not recommendations to buy, these are just their current favorites. Make sure you do your own research to see if these or any other stocks meet your needs.)
Johnson & Johnson
This dividend payer was a favorite for many of our bloggers. Here is what they had to say:
My favorite dividend growth stock is Johnson & Johnson (JNJ). It’s my largest holding, for good reason. The company has increased its dividend for the past 53 consecutive years, which comes about because the company has grown incredibly over that period. It’s the largest diversified healthcare company in the world, with exposure to pharmaceuticals, medical devices, and consumer healthcare products. With a world that’s becoming bigger, richer, and older, they should do well in a future where increased access to high-quality healthcare is a growing priority. – Jason, Dividend Mantra
I think new investors should consider JNJ, since it has an exceptional track record of paying growing dividends (53 years!). Current yield is 3%. Payout ratio is 50%. 10-yr DGR is 9.7%. JNJ has a perfect AAA credit rating and a Safety score of 1 from Value Line. The company has solid fundamentals and several new growth drivers. I’m going with JNJ! – Ferdi, DivGro
Everyone knows about the JNJ’s long track record of raising dividends and returning value to shareholders, but this healthcare behemoth also continues to innovate and evolve as a result of R&D and the company’s sponsored business incubator. Plus, the majority of sales (both net and gross) are within the global healthcare space which looks promising for years to come as a result of global demographic trends. Disclosure: I own JNJ. This is not a recommendation to buy/sell/trade any security. – Bryan, Income Surfer
JNJ is simply one of the best dividend stocks around. The company has raised its dividend for 52 years, a rare achievement among dividend paying companies. Though not always fairly priced, it is often. And with JNJ, there is not much surprises. You can generally expect reasonable and relatively steady dividend growth, generally between 7 to 10% per year. With a yield which generally hovers around 3-3.5%, JNJ is a safe bet. JNJ also operates in a mostly recession-proof business, i.e. healthcare. And its combination of various healthcare business units, i.e. consumer products, pharmaceuticals, orthopedics and medical devices allows its earnings growth to be steady since not all its business units grow at the same pace. If you don’t know where to start as a dividend investor, start with JNJ. – Frank, Dividend Engineering
My stock is Johnson & Johnson (JNJ). This health care giant has increased its dividend for 52 consecutive years. J&J’s payout ratio stands at a healthy 50%, so investors can expect the dividends to keep flowing. Johnson & Johnson has three primary operating segments. First is its consumer health products segment, the second segment is its medical devices and diagnostics division and third is its pharmaceutical operations. These three well-functioning segments ensure an increasing dividends also in the future. – Antti, Dividend Hawk
From there, many of our bloggers liked different stocks for various reasons. In no particular order, here are the rest of their selections.
BLK is THE asset manager in the US with the largest market share (AUM) with its iShares division. With over $1 trillion invested in its ETFs, BLK shows more than double the AUM of the secondplace State Street Corp. BLK impresses with better profitability than its peers. BLK now shows $4.774 trillion in assets under management. This means lots of management fees to be earned for the company. – The Dividend Guy
Chevron (CVX) is my all-time favorite dividend growth stock. I was given one share as a gift in 1995 by my uncle. He explained that if I invested money consistently over a long period of time and reinvested the dividends, the dividends would eventually buy more whole shares, compounding my holdings. It’s now been 20 years of owning the stock, and I wrote about the performance on my blog and Seeking Alpha. Historically, when the stock yields above 4% it’s been a good time to start investing. Today it’s yielding 4.3%. – Retire Before Dad
My pick is Starbucks (SBUX), even though I do not own this stock my portfolio. A dividend grower for 4 years, yields a modest 1.18%. The company is one of the best run beverage business and is constantly innovating. – Sabeel, Roadmap2Retire
My favorite dividend paying stock is AT&T. I’m not a fan of their high priced cell phone service, but they’ve been around for seemingly forever and don’t look to be going anywhere anytime soon and thus offer a relatively solid business model. Most importantly, T is a dividend aristocrat which is something I look for when investing in individual stocks. With a current yield of a little over 5.25% they provide decent return for my dividend income. – John, Best Discount Brokerages
I always liked the concept of owning stocks like Ameren and Verizon. Why? Because it felt like they were helping me offset my heating and cell phone bills. One way to knock down your expenses! – Jeff, Good Financial Cents
Bank of Montreal
I will have to say my current favorite is BMO.TO. My reason for why I choose this company as one of my favorite dividend growth stock is very simple: 180 years of consecutive dividends to shareholders. When it comes dividend growth investing (and anything else in life) consistency is what separates success from failure, and BMOs dividends couldn’t be any more consistent. – Ace, Dividend Digger
Vanguard REIT ETF
This diversified real estate investment trust has holdings including office buildings, hotels, and other real property. With a 4% yield today, it offers a nice dividend. But beware, with interest rates poised to rise, and the fact that last year dividend stocks underperformed realize that high dividends don’t always mean high returns. Always check the valuations of the underlying holdings of any investment before diving in. – Barbara, Barbara Friedberg Personal Finance
Bank of Nova Scotia
My pick is The Bank of Nova Scotia (BNS). i am a fan of all the large Canadian banks as their current price/valuation make them attractive going forward. having a current sustainable yield north of 4% is also a great way to get paid while we wait for interest rates to rise and provide greater profitability for these bank stocks. – Keith, DivHut
My portfolio is heavily focused on Australian stocks at the moment and has variety of different stocks, but on the dividend front, my favourite one I own is Woolworth’s, a major supermarket chain here in Australia. Since 2006, dividends have increase every single year, from $0.51 per share to $1.37 per share. It currently pays a pretty juicy dividend yield of 5.1%, which is even higher than its very solid average of just under 4% over the last 10 years. The business is facing a few challenges at this very moment, but I’m confident they’ll still be paying higher dividends in another 10 years, regardless of how the industry and competitors evolve over that time. The bonus with investing in Woolworth’s stock, along with most dividend stocks in Australia, is our dividend imputation system. It effectively gives an additional 30% boost to the dividend value in the form of a tax credit! – Jason, Islands of Investing
My favorite, and I am sure I am not going to be the only one with this response, is Kinder Morgan (KMI). Over the several years, management has really focus on creating shareholder value through consolidation of entities, dividend increases, and other measures to drive the company to become market leader in the pipeline industry. What’s better? Management has committed to increasing their dividend 10% annually through 2020, which makes their current 4.85% yield look that much better. – Bert, Dividend Diplomats
I’d have to say, right now – International Business Machines (IBM). Their growth rate is phenomenal, payout ratio is sound and their share buyback program allows them a further flexibility in having such strong dividend growth. They are yielding higher than their historical 5 year average, are above the S&P 500 yield as whole and are close to 2.5x my portfolio’s dividend growth rate. The yield on cost, which we talk about on our blog, increases at an alarming rate with this “Big Blue” company. – Lanny, Dividend Diplomats
So to recap, make sure you are doing some research into which stocks you should invest in.
- Don’t invest in the first stock you come across
- Don’t base your decision solely on dividend yield
- Do make sure you are diversified
- Do make sure you have a plan
Where To Invest In Dividend Paying Stocks
Finally, we need to talk about the broker you are going to invest with. Since most brokers charge a commission for investing in stocks, you want to find one that not only has low commissions but also one that meets all of your needs. This is because fees matter when it comes to investing. The higher your fees, the lower your potential return (or the longer you have to wait for a gain). You can start your research off with my online broker comparison chart.
But I will save you a little time with some thoughts on my own:
Motif Investing is a great choice because you can build a “motif” of a handful of good dividend paying stocks and invest in them all at once for $9.95. Considering you can invest in multiple stocks for this price makes them a top consideration.
In fact, they have hundreds of ready make portfolios of dividend paying stocks for you to choose from. Here are just a handful I found.
The downside is that they do not have an automatic dividend reinvestment plan. When you do receive dividends, they will go into your cash account and you will have to invest the money back into the stocks. You can read more about them in my review.
Capital One Investing (formerly Sharebuilder) allows you to invest in stocks for just $6.95 per trade and will let you reinvest dividends for free automatically. To learn more about them, my review can be found here.
To read about all the latest broker sign up deals, be sure to check out this page.
I hope that this post showed you the power of dividend income. If you require further proof of the power of dividend income, be sure to click through to the other bloggers I noted above. On their sites you will see how they have used dividend income to grow their wealth substantially over the years.
Readers, what are your thoughts in dividend income? Is it something you do now or plan to do?
[Photo Credit: fsecart]