Not all investors want to take on the risk that comes with making a killing through stocks. (Hey . . . no guts, no glory!) Some people just want to invest in the stock market as a means of providing a steady income. They don’t need stock values to go through the ceiling. Instead, they need stocks that perform well consistently.
If your purpose for investing in stocks is to create income, you need to choose stocks that pay dividends. Dividends are typically paid quarterly to stockholders on record as of specific dates. How do you know if the dividend you’re being paid is higher (or lower) than other vehicles (such as bonds)?
The difference between dividends and interest
Don’t confuse dividends with interest. Most people are familiar with interest because that’s how you grow your money over the years in the bank. The important difference is that interest is paid to creditors, and dividends are paid to owners (meaning shareholders — and if you own stock, you’re a shareholder because shares of stock represent ownership in a publicly traded company).
When you buy stock, you buy a piece of that company. When you put money in a bank (or when you buy bonds), you basically loan your money. You become a creditor, and the bank or bond issuer is the debtor; as such, it must eventually pay your money back to you with interest.
The importance of an income stock’s yield
When you invest for income, you have to consider your investment’s yield and compare it with the alternatives. The yield is an investment’s payout expressed as a percentage of the investment amount. Looking at the yield is a way to compare the income you expect to receive from one investment with the expected income from others. Here are some comparative yields.
| Investment | Type | Amount | Pay Type | Payout | Yield |
|---|---|---|---|---|---|
| Smith Co. | Stock | $50/share | Dividend | $2.50 | 5.0% |
| Jones Co. | Stock | $100/share | Dividend | $4.00 | 4.0% |
| Acme Bank | Bank CD | $500 | Interest | $25.00 | 5.0% |
| Acme Bank | Bank CD | $2,500 | Interest | $131.25 | 5.25% |
| Acme Bank | Bank CD | $5,000 | Interest | $287.50 | 5.75% |
| Brown Co. | Bond | $5,000 | Interest | $300.00 | 6.0% |
To calculate yield, use the following formula:
yield = payout ÷ investment amount
For the sake of simplicity, the following exercise is based on an annual percentage yield basis (compounding would increase the yield).
Jones Co. and Smith Co. are typical dividend-paying stocks. Looking at their statistics and presuming that both companies are similar in most respects except for their differing dividends, how can you tell whether the $50 stock with a $2.50 annual dividend is better (or worse) than the $100 stock with a $4.00 dividend? The yield tells you.
Even though Jones Co. pays a higher dividend ($4.00), Smith Co. has a higher yield (5 percent). Therefore, if you have to choose between those two stocks as an income investor, you should choose Smith Co. Of course, if you truly want to maximize your income and don’t really need your investment to appreciate significantly, you should probably choose Brown Co.’s bond because it offers a yield of 6 percent.
Dividend-paying stocks do have the ability to increase in value. They may not have the same growth potential as growth stocks, but at the very least, they have a greater potential for capital gain than CDs or bonds.