The ultimate dividend paying portfolio: Part I

In today’s ultra-low interest rate environment, companies that pay dividends are becoming increasingly attractive. These companies can yield anything from 3 to 11%, and many of them increase their payouts over time. This article examines the subject of dividends and presents the ultimate dividend paying portfolio.

What are dividends?

Dividends are regular payments made by a company to its shareholders. Usually paid on a quarterly basis, dividends are a way for companies to share their earnings with the owners of the company, i.e. the shareholders. Dividends can either be paid to the shareholder in cash or they can be reinvested in the company’s stock.

The type of companies that pay dividends tend to be stable, established businesses rather than those that are focused on growth.

Why own dividend paying stocks?

Aside from the obvious fact that they provide income, dividend paying stocks are attractive for a number of other reasons.

Not only do dividend paying stocks offer income, they also offer the potential for growth. In fact, the income produced by dividend-paying stocks has been a valuable component of equity investing for more than a century. Between 1926 and 2010, 44% of the returns generated by the S&P 500 index came from dividends.

Dividend paying stocks are usually less volatile than those that don’t pay a dividend, and they also tend to do better during periods of market turmoil. In 2008, for example, stocks that paid dividends lost an average of 39% on a total-return basis, while those that didn’t pay a dividend fell by 45.4%.

An investment in a company with a long history of paying dividends also provides investors with added confidence, since it is a reflection of a well run company with a strong cash flow. Companies that are able to consistently raise their dividend also tend to be focused on delivering value to shareholders, and this is another sign of a company with a solid balance sheet. In short, dividends don’t lie. A company either has the cash to pay the dividend or it doesn’t.

Dividends are particularly attractive in today’s environment of ultra-low interest rates, in which most savings accounts yield little more than 0.5%. Interest rates are at historic lows and cannot fall much further. It is therefore likely that over the next few years rates will begin to rise, and rising rates would mean losses for many fixed-income investors, particularly those holding bonds.

How are dividends calculated?

The majority of companies pay their dividends quarterly, meaning that at the end of every business quarter, the company will send out a check for a specific amount.

Example: On 28 March 2013 BP plc (LON:BP) paid out its Q4 2012 dividend, a payment of 60013p paid per ordinary share. Therefore, if you held 100 shares of BP, you would have received £6.0013.

There are different ways to calculate a company’s dividend yield, however the most accurate way is to use the total value of the previous year’s dividend payouts (usually the last four), and divide that by the current share price.

The four dividend payouts BP made during 2012 were as follows: Q1 £0.051498, Q2 £0.050171, Q3 £0.055890, and Q4 £0.060013, that means that the total twelve-month trailing dividend was £0.217572. This number divided by a current share price of 4.5378 gives BP a dividend yield of 4.79%.

What to look for in a dividend paying company

Just because a company has a high dividend yield at the present time, does not mean that it will have a high yield in the future. For this reason it is important to find companies that have a long history of paying dividends. Coca-Cola, for example, has paid a dividend every year since 1920.

Another thing that is important when choosing dividend paying companies for your portfolio, is to find those that have a history of increasing their dividends over time. For example, over the past 10 years, McDonald’s has increased its dividend by around 900%.

Proctor & Gamble is another example of a company that has never missed a quarterly dividend payment since 1890, and has increased its payment for 55 years in a row.

Investors need to screen stocks carefully since those with the highest yields are not always a safe bet. Gaining a thorough understanding of a company’s financial health is the key to this screening process.

View part two of The ultimate dividend paying portfolio here.

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