When I was young, I loved getting on my bike and chasing storms. I dreamed of one day being a storm chaser just like the people on TV who film themselves driving in their car down deserted Oklahoma highways chasing tornadoes. At that age, however, I was undoubtedly unaware of the potential risks of chasing giant storms after what seemed like such an exciting and exhilarating event that I was invincible to. Dividend chasers are much like my storm-chasing-bike-riding young self. Was that segway a bit of a stretch?
When choosing stocks for your portfolio, there are many things that can be considered that will influence your decision on what companies to buy. Some people choose to weigh qualitative metrics (such as company outlook for the future, sector health in the economy, corporate social responsibility actions, CEO likability, business ethics) heavily in their decision making process, while others look at more quantitative metrics instead (such as fundamentals like earnings and profitability ratios, technical charts like momentum graphs and volume charts) - Quantitative metrics are always the most important and meaningful by the way!
One of the most sought after quantitative metrics is a stock's dividend. Which stock has a dividend? Which stock has the highest dividend? When do I get a dividend? These are common questions you may have heard one of your colleagues or friends ask when deciding which stock to buy. While dividends are a great way to provide returns and incentivize investors to purchase stock, they can also be quite misleading. Let's look at the concept of a dividend.
A dividend is a set dollar amount per share that is paid out on a periodic basis, typically quarterly or sometimes monthly. A company will announce or "declare" when a dividend is to be paid to shareholders of that stock as of a particular date in the future, or commonly called the "ex-dividend date". You must own the stock at least the day before the ex dividend date to receive the dividend for that announcement period (for that quarter or month). The ex-dividend date will usually be a few weeks prior to the date when the actual dividend is paid out in cash (the payable date).
Although dividends are issued as a dollar per share amount, typically they will be shown as a percentage. This percentage is based off of the current share price. For example, if company ABC pays a $1/share annual dividend and the current stock price today is $10, the dividend would show as 10%. However, if the stock climbs to $20, the dividend is still $1/share, but is now shown as 5%. So purchasing 100 shares of ABC at $10 will ensure $100 of dividends on your $1000 investment for the year. If you purchase 100 shares of ABC at $20, you are getting the same $100 of dividends, but your return is calculated off of your $2000 investment.
Many investors will "chase yield" or chase dividends when they see stocks paying outrageously high dividends: 10%, 20%, or even +30%! . However, be careful because this can be misleading. A high dividend percent can sometimes be correlated to a plummeting stock price. If a year from now, company ABC still pays a $1/share dividend but the stock ticker shows a dividend percent of 25%, that means ABC stock price would be $2.50. It plummeted from $10 to $2.50! This plunge in the stock price, which most likely would be due to poor current and projected financial performance, may often be overlooked because of the attractive high dividend percent. Also keep in mind that if a company starts losing money and the EPS (earnings per share) for a given year decreases, the dividend may not be affordable anymore for the company. As a result, the dividend gets slashed, and shareholders become upset and a sell off will ensue.
So why not look for these high paying dividend percent companies and buy them the day before the ex-dividend date, and just sell them the day after? Well unfortunately that's not how it works. Because dividends are issued on a per share basis, the stock price will initially drop by that exact per share amount (remember the stock price is a "per share" price too) on the ex-dividend date when the market opens. But to get the dividend, you must own the stock by the close of the trading day before, so avoiding the opening of the market the next day is impossible. If ABC company issues their $1/share dividend, the current stock price of $10 per share will quickly drop to $9 per share on the ex dividend date. Now this drop in the stock price is usually never clearly seen because of how much a stock price fluctuates in a day, but it occurs nonetheless.
Dividends are a great way to generate a guaranteed annual cash flow and is a common strategy for a company to return value to their shareholders. Looking for stocks that consistently pay and increase dividends every quarter can give a nice steady boost of income to any portfolio. Some companies will refuse to pay dividends and instead reinvest that extra money back into the company to grow the business and provide returns to their shareholders through an increase in stock price over time. Personally, I prefer investing in companies who exercise the latter option, but owning a mix of dividend and non dividend paying companies is one way of diversifying an investment portfolio.
It's important to investigate why a company pays a dividend, how the recent trend of a stock price trend has affected the dividend yield and the reason for the price movement, and whether or not the dividend is sustainable (i.e. can the company continue to afford paying the current dividend given its current and projected earnings). Realizing these key points will hopefully make investors aware of whether or not they are choosing a stock with a consistent and increasing dividend every quarter, or chasing a high paying dividend hopeless company that inevitably will go to zero. Remember, if something looks too good to be true, it's because it usually is. Don't be a storm chaser!