The Divine Dividend: Icing on the Cake!

“The plans of the diligent lead to profit as surely as haste leads to poverty”.
—Proverbs 21:5 (NIV)

Have you ever watched Ace of Cakes? Chef Duff takes cake making to a whole new level! From shaping cakes with drill saws and blowtorches to staffing his bakery with rock musicians, he's far from your typical baker. However, he's one of the most sought-after decorative cake makers in the country. Every week at Charm City Cakes in Baltimore, Duff and his team of artists try to meet the demands of creating up to 20 cakes a week, some of which take up to 29 hours to build! From a tilted Dr. Seuss-like seven-tiered wedding cake to an almost perfect replica of Wrigley Field, Duff can build it. With cake making, the cake itself is the tasty treat, but the icing is where most of the magic occurs.

Likewise, investors seeking a tasty treat get the “icing on the cake” with dividends. While stock appreciation is by far the most sought-after treat, a company paying a regular dividend can be icing on the cake. However, just as with any investment, there are many things you should consider.
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Dividend Basics

By definition, a dividend is simply a portion of a company’s profits paid to its shareholders. There are cash dividends, stock dividends, and special one-time dividends. Special one-time dividends are an uncommon occurrence and can be issued in the form of cash, stock, or property dividends, usually as a special benefit to shareholders for something such as the sale of a portion of the company’s business, liquidation of an investment, or maybe a major litigation victory. Stock dividends are basically “stock splits,” whereby shareholders receive extra shares of the company’s stock, instead of cash, as a means to reward shareholders, lower the stock price, or increase liquidity.

Let's focus on cash dividends, which are regularly scheduled payments made by a corporation to its shareholders. The majority of companies pay dividends quarterly, four times a year. However some pay annual, biannual, or even monthly dividends. Just as my son watches for certain opportune times to grab tasty food, there are key points in time to be aware of when investing in dividend-paying companies:

• The declaration date is basically when the board of directors declares or approves that the company will pay a dividend and announces the date of record and payment date.
• The date of record is the date on which the company reviews its records and determines exactly who are the shareholders of the company’s stock.
• The date at which the dividend will actually be given to the shareholders of the company is termed the payment date.
• By far the most important date for dividend investors is the ex-dividend date. Quite simply, if you want the dividend, you have to purchase the stock before the ex-dividend date.

How Do Dividends Work?
Let’s say you own 100 shares of Annaly Capital Management NLY and they pay an annual dividend of $2.56. As they pay a quarterly dividend, you would receive $64 ($0.64 per share) every quarter for a total of $256 ($2.56 per share) per year, regardless of the stock price. And this is where the term “dividend yield” becomes important.

Stagnant growth can also be associated with many dividend-paying companies. While this is not always the case, many companies experiencing growth problems, commonly due to the “how big can you get” factor or lack of newer products, will sometimes try to retain shareholders by declaring a dividend. And while this isn’t always a bad thing, it is something to be aware of. In addition, some companies may better serve shareholders by not paying a dividend and using the capital to grow business. Nonetheless, investing in high-quality, dividend-paying stocks is a great way to build long-term wealth. Dividend-paying companies can also be an added bonus, providing consistent positive returns even during hard times such as the recession we are currently in. Yes, a good dividend-paying company can really be icing on the cake!

In the Annaly Capital Management example, if NLY is currently trading at $17.77 per share (as of March 17th 2011), the dividend yield is equal to 14.4 percent. This equation is simply written as: annual dividend ÷ current stock price = dividend yield.

The Divine Dividend
Now that we have the basics out of the way, let’s get to the icing. The easiest way to explain the long-term benefit of dividend investing is to utilize an example. Let’s say you bought 100 shares of a dividend paying company priced at $10 per share and held these shares for ten years. Let’s assume the company had an annual growth rate of 7 percent, a dividend yield of 3 percent, and the annual dividend growth rate was 1 percent. If you reinvested all of your dividends, after ten years this initial $1,000 investment would be equal to $2,441.98.

Now let’s say you also bought a similar company, but it was a growth company that does not pay a dividend. Using the same scenario above, 100 shares of this growth company at $10 per share held for ten years with and an annual growth rate of 7 percent would grow your initial $1,000 investment into $1,967.14. As you can see, the dividend paying company netted you an additional $474.84 over the ten year period. That’s the icing on the cake—a higher rate of return!

Cakes and Caveats
Just because a company is paying a dividend doesn’t mean it is a good investment. Sure, sometimes you can have your cake and eat it too, but be warned, sometimes your cake can eat you. Here are some things to consider: A high dividend yield doesn’t always equal a high-quality company. Take a stroll through the financial sector and you’ll quickly see what I mean. Once prominent high-dividend-yielding companies, like Citigroup C, Bank of America BAC, and many others have slashed or even stopped paying dividends—not to mention the horrendous depreciation in their stock prices.

Instead, at Faith-Based Investor, we look for high quality dividend paying companies that have a history of consistently raising dividends. There so far, we have found a great recipe for success!