How to Make Money with Dividends

Dividend Definition

P/E Ratio

P/S Ratio

P/B Ratio

Payout Ratio

A few years ago, I reached a place where I had saved up about $20 000 that I was interested in investing in the stock market. I did extensive research for about a year, looking at the various options. Eventually, I settled on dividend stock investing because it seemed not so complicated, not so risky and could offer good returns if done for the long term. I started investing about 2 years ago, and have a steady stream of dividends coming in every month, about $200 or so. I keep investing more money that I make from my job, as well as the dividends. I hope to grow this monthly income to over $1000/month.

You're a newbie and want to know the basics? Well, dividends are simply earnings that a company pays out to its shareholders. Most companies pay 4 times/year, at a set amount/share. The only fees for this investing strategy are the commission that you pay to buy the stock (from $3-$20) and the same fee when you sell the stock. If you sign up with an online discount broker such as Sogotrade, your fees will be minimal.

As with any investing, do your research first and act second. This site is a good place to start!

It's easy to make passive income, online through investing in dividend paying stocks. Dividends are simply earnings that are paid out to shareholders of the company. Here's how it works:

1. First, you need to sign up for an online discount broker. I use www.Sogotrade.com because they have the cheapest commissions around ($3/trade). Transfer some money into this account.

2. Do your research. I use Yahoo or Google Finance to research the stocks I want to buy. For a start, search online for things like "dividend achievers or dividend aristocrats" to find stocks that have a good history of paying increasing dividends.

3. Look for stocks that are "cheap." While people have many different ideas of what this means, I generally look for those with a P/E (price/earnings) ratio of 12 of less. And a low P/S (price to sales) and P/B (price to book) ratio compared to the other stocks I'm looking at. Also, make sure you check the payout ratio. If it's more than about 60%, the company is paying out too much in dividends and may not be able to sustain your payout in a downturn.

4. Make your trade. I use the "limit order" for all trades that I make. Set your limit for a price a little bit below where the stock is at now. If you use a "market order" you might get stuck paying a higher price than you want if the stocks goes up overnight and opens much higher than expected.

More details on specific stocks in my portfolio to come!

Once you start buying dividend paying stocks, you'll start seeing the money roll into your brokerage account. At this point, you have 3 options:

1. Reinvest the dividend payments back into the same stock that paid you.

2. Invest in some other stock.

3. Take the money out of the account and use it.

If you're in retirement, and need the money then option #3 would be the best for you.

I don't like option #1 because maybe the stock that paid you the dividend is not cheap at this point in time. I like to think of investing as shopping. You wouldn't want to buy things that aren't on sale, right? And everyone likes a good deal, do they not? So, why would you just blindly buy a stock without looking at some basic things like P/E ratio? It just doesn't make sense. Another reason for not doing this option is that perhaps you only get a $50 payout from a stock. You can maybe buy 1 share of something. But, when you get charged $5 or $10 commission for the trade, it's just eating up too much of your profits.

And that leaves us with option #2. Here is my strategy: I pool my dividend payments and wait until I get about $2000. Then, I do some research and find a stock that looks cheap. I buy $2000 worth. I will usually buy a new stock, since my goal is to get as diversified as possible, reducing my risk of catastrophe should the markets go down, or a company go bankrupt.

The short answer is almost never. The whole thing with a dividend paying strategy is that you don't really care so much about the stock price (after initially looking for companies "on sale" when buying). It goes up, it goes down, it doesn't really matter as long as your dividends are rolling in. The key to dividend investing is "yield on cost." If you paid $10 for a stock with a 3% dividend and the dividend increases by 10%/year for the next 20 years, your yield on that original $10 will be significantly higher than 3%. This strategy won't work though if you keep buying and selling. This frequent trading also increases your trading costs, which can significantly lower your returns.

So when should you sell?

1. If the company lowers its dividend. This is not an automatic sell for me and I would consider it on a case by case basis.

2. If the company loses its competitive advantage. For example, you are invested in a company that gets most of its revenue from land-line phones. They haven't been able to gain any market-share in the cellular market. I would consider selling as this company has a sad future ahead of it.

3. When the payout ratio gets too high. I generally don't buy stocks that one over 60%. If, in a few years time, one of my stocks gets up to 80 or 90%, I would consider selling. The writing is on the wall for lowered dividend growth or a cut.

When you're looking to buy some dividend paying stocks, I know it's tempting to fill your portfolio with the highest paying stocks that you can find. Something like Chimera (CIM) at 17.6% or Frontier (FTR) at 7.9. However, there are a few problems with this strategy:

1. If the yield is much higher than its peers in the industry, something is probably not right. For example, Frontier has a payout ratio of over %300. They're paying out 3 times more in dividends than they're making in cash. Where are they getting this money and how can they possibly sustain it? I'd be worried about a stock that has a payout ratio of over 80%. Less than 50% is even better and possible to find.

2. Some of the REIT's (Real Estate Income Trusts) pay huge dividends (like Chimera). They can do that now, because the interest on the money that they borrow to finance their business is so low. Interest rates are guaranteed to go up and with it, REIT's profits (and high dividends).

3. Anyone can pay out a very high dividend for a couple years, especially if they're willing to borrow money to do it. However, this is not good for the health of a company and sustainability for the long term. I want my dividend payed out of earnings. And I want a company that has been growing its dividend for at least 10 years, without any cuts, or long periods of stagnation.

So, do high dividend paying stocks have any place in your portfolio? Yes, they do, but only a small one. Think less than 10%. I personally have money in NLY and AINV, which both pay significant dividends

You hear stories all the time of people who struck it rich, by buying one stock that went up some outrageous amount. And of course that person was smart enough to buy when it was low and sell when it was high. Except for every one of these stories, I have a feeling that there are plenty of other stories of tragedy and loss (think Enron). What is a better way?

The financial experts generally recommend about 20-40 stocks in a dividend stock portfolio. This provides a nice balance between a decent return and protecting yourself in case one or two of the companies doesn't perform that well or goes bankrupt. Basically, while it would hurt your return if a company goes under, it would not devastate you. Also, this number makes it easy for you to keep track of what's happening in all your companies. Any more than 40 is just too many to follow.

A good place to start is the dividend aristocrat list. These are companies that have been raising their dividends for the last 25 years. Another place is the dividend achievers list, who have raised their dividends for 10 years. If you want an extremely simple way to invest in these kind of companies without doing much research, do a google search for these lists. Look on Yahoo Finance and find out what each stock's payout ratio is. If it's under 50%, the dividend will be sustainable for at least the next few years, barring a major disaster. Rank them according to P/E ratio and buy $1000 or $2000 of the each of the "cheapest" ones. You could also eliminate the ones with only 1 or 2% dividend because even though it's growing, the starting place is just so low.

Maybe you work for a company that has dividend paying stock. And your co-workers are always talking about stock prices and dividends and how it's a can't lose thing. Should you buy the stock of your own company though? Here are some things to consider:

On the plus side:

I would buy, ONLY IF your company offered you a discounted price or a match of some sort. Say 10% discount to the market value. Or, for every share you bought, they matched it with one more. If not, I'd take a pass. And, if I did buy, I'd be careful not to have more than %10 of my portfolio in the company that I worked for.

Why? Because you don't want to have all your eggs in one basket. You already make all your money from this company. Now, say the company goes bankrupt and you lose your job. Or, there's a downturn and you get laid off. It's going to hurt you, but it won't be so bad if you have all your money invested in other companies and are still earning dividends from them. The short-term is bad, but the long-term is still secure.

Now, imagine that you had all money invested in the company that you worked for. They go bankrupt. You lose both your job and your life savings. Or, if you are laid off. If the company is laying off people, times are bad and stock prices are sure to go down. Hopefully you don't have all your money invested in this company.

You should always invest in companies that you understand. Warren Buffet, one of the most successful investors ever follows this strategy. Unless you're an expert in the tech industry, then this probably isn't the place for you to invest. Changes happen so rapidly that unless you know where the future is headed, you could get stuck with stocks that are going nowhere.

Some good things for beginners to invest in? Stick with oil (Chevron, Exxon Mobil), fast-food restaurants (Mcdonalds, Yum Foods), soda (Coca Cola, Pepsico), consumer paper products (Kimberly Clark, Clorox, 3M, Proctor & Gamble), and big retailers (Wal-Mart).

Emotional people will never be good investors unless they are able to overcome them and invest in a systematic, controlled kind of way. For examples, during the market crash of 2008, people were scared. They were seeing their life savings disappear in the blink of an eye and for those nearing retirement, this was a very frightening experience. So what did most people do? Well, according to the market data, there was a huge sell-off during this time period. People panicked and sold their stocks when they reached the rock bottom. Most people took a tremendous loss. If they had relaxed, and realized that what goes down, must come up and held onto their stocks, they would have regained most of their losses in the next couple years, as there was one of the best bull markets in recent history.

What should people have been doing? When stocks are cheap, they're on sale and people should have been buying. In the 2008 bottom, it was like the best Black Friday sale you'd ever see in your lifetime. So why were people not lining up to buy everything they could? Because they were scared and following the herd. Everyone else was selling, so people thought they should too.

Control your emotions! When everyone else is scared and fleeing, don't get caught up in the panic. It's the time to buy. And when the stock market is riding high and people are dying to invest in the next high-flier, stop buying. Things will go down and you'll be able to buy things cheaply later

I would recommend that you have at least $5000 to get started with this for the following 2 reasons:

1. You should never have all your eggs in one basket, as the saying goes. If you only have $5000, then you really shouldn't buy more than 2 or 3 stocks, which is quite risky. What if one of the companies goes bankrupt? You'd be devastated. If you had 10 stocks and that happened? Well, not so terrible.

2. Trading costs are very high if you buy small amounts of stocks. I suggest a minimum of $2000 per trade.

A reasonable amount of money to start investing in dividend paying stocks is $10 000. This way, you could pick 5 stocks to start out with and put $2000 into each one. Then, keep saving your money and adding another $2000 to buy one more stock. You'll eventually build up to the approximately 20 stocks that you should have in your portfolio over time. Once you reach 20 stocks, it's time to consider adding more money to your current holdings (another 2000) or buying additional new stocks.

Some of the dividend stocks that I hold in my own portfolio are:

Oil Companies: Chevron, Exxon Mobil, and Conoco Phillips

Pharmaceutical Companies: Bristol Myers, Glaxosmith Kline, Johnson and Johnson

Consumer service Companies: McDonalds, Wal-mart, and Kimberly Clark

Telecommunications: AT&T, Telefonica

One of the biggest factors in predicting your annual return is trading fees. If you pay $20/trade, it's very difficult to overcome this and actually make money, especially if you're a frequent trader. By lowering your trading costs, you can overcome them quite easily and hopefully make money on your stock purchases. Think about it another way. By only paying $3/trade, I'll make that money back for sure the first time my company pays me a dividend. And I'll have plenty of money left over to keep investing. By paying $50/trade, it will probably take up the whole first dividend and possibly part of the second or third.

I did lots of research when I was beginning to invest and the cheapest discount online brokerage that I found was
Sogotrade I've been with them for a couple years now and am generally satisfied with them. Trades are really only $3, with no extra hidden fees. It's almost too good to be true, except it's not!

The P/E Ratio is defined as:

A valuation ratio of a company's current share price compared to its per-share earnings.

Calculated as: Market Value per share/ Earnings per share (EPS)

Historically, the P/E ratio averages around 15. Simply put, if it's higher than 15, stocks are considered expensive. It's it less than 15, stocks are considered cheap and present a buying opportunity.

When I'm looking at what dividend paying stocks to buy, the P/E ratio is most often what I look at. However, the P/E ratio that you see on the main page of finance websites is the current P/E ratio, denoting the past earnings. Buying stocks based on past performance is not really a good indication of future results, so it makes more sense to look at the "forward P/E ratio." It looks at the predicted earnings for the next year and shows how expensive the stock is in relation to that. This is a better indication on stock performance since it's forward looking.

The payout ratio is easy to find by looking up the basic stats about a company on a site such as Yahoo Finance or Google Finance. It's most commonly showed as a percentage. It's basically the amount of company earnings that are being paid out in the form of a dividend. It's such an important stat because it can give you an idea of whether or not the company's dividend is sustainable or not.

If the payout ratio is above 100% it's clear the company is paying out more money than its bringing in. They are doing this through leverage (debt), or by making more shares of their stock. Neither of these are particularly good for you, the shareholder. The dividend is also likely to be cut in the future, since most companies can't sustain this for more than a year or two without harming their company.

When I'm investing in a company, I look for a payout ratio of less than 50%. It shows me that the company is responsible with their finances and that they probably won't cut the dividend. They also have room to raise the dividend in the future.