Dividends are when a company pays its shareholders cash for holding those shares. This cash is given from a portion of the profits that the company is making, so when the company is making money, you’re making money.
There’s three good things to know with dividends: yield percentage, dividend growth, and dividend coverage. All three are simple enough but need to be understood.
If you see or hear about dividends people always say “dividend yield.” This means that it makes the cash that it pays out a percentage of the stock price so you understand how much money you’re actually being paid. A dividend yield of 3% would mean that: for each $100 in stock you own, you as a shareholder will be paid $3 cash each year. You might think that’s nothing, but it’s free money essentially. Plus, companies can GROW their dividend so you make more and more and more cash each year.
I touched on this in the last section. A common strategy among investors is to look for companies with a good dividend yield and that is growing that yield regularly.
For example, Coca Cola (KO) pays a 3% dividend this year. You invest $100 and at the end of the year you have $103. After this year, Coca-Cola has grown and people have come over from the dark side from Pepsi. They increase their dividend 5%. Now your yield is 3.15%, and at the end of the second year you have $106.24. This keeps occuring with the cash being paid out and the dividend keeps being increased and reinvested. After 40 years your $100 is now $3083. This might seem small but keep in mind that over 40 years the stock price will go up A LOT too and so that number is a fraction of what the total investment will be worth in the end.
Dividend coverage is harder to calculate but easy to understand. The dividend is paid from a company’s profits, so if the company isn’t making enough money to cover their cash payments to the shareholders, they might cut their dividend yield. Also, if the dividend coverage is 80%, for instance, it means the company only has 20% of its profits to continue to grow the business. Looking for an established company (or growing?) that has a lower dividend coverage will ensure that the company can keep growing its business and the dividend payout itself.