The five Ws of dividend investing

Morningstar's Josh Peters, editor of US publication dividendInvestor, explains the five Ws of dividend investing: the what, when, where, why and who of dividends; and why it's so important to understand them.

You can read the full transcript below.

Josh Peters: Hello. This is Josh Peters, Editor of Morningstar's DividendInvestor newsletter. Now, if you listen to a lot of market commentary, chances are you hear dividends referenced these days quite a lot--whether some companies are cutting their dividends, others are still raising them, how dividend yields are playing in, whether or not dividend paying stocks are outperforming.

But, let's back up a second, and for newer investors or people who are newer to dividends, take a look at the "five Ws" of dividends, what can we learn about the basics that can help us understand how these dividends work in favour of investors.

So, let's get right down to business.

What is a dividend? A dividend is very simple. It is a cash payment that a corporation makes to its shareholders, each share receiving the same amount of cash. To use an example, consider Kraft Foods, the symbol there is KFT, and one of the companies that I think is a pretty good payer of dividends.

Every three months or thereabouts, the company's board of directors declares a dividend and recently it has been $0.29 a share. If I own 100 shares of that stock, of Kraft stock, then I will receive a check or deposit to my brokerage account of $29.

One of the nice things about a dividend, unlike other types of gains and profits in the stock market, it's money you never have to give back.

Now, before we move on to our next W, we also have to ask another "what" question about this dividend, which is "What does it mean to me?" Is $0.29 a good dividend or a bad one?

Well, in the case of dividends, what you want to do is not think about the dollar amount per share so much as the dividend yield. In the case of Kraft, this dividend yield has been running in the four percent area. What this does is, it tells you over the next 12 months how many dollars worth of dividend should I collect for a share and then that divides it by the current stock price.

What it does is, it kind of puts it on a par with an interest rate or a yield. In fact that is why it is called the dividend yield, because you are getting a sense of how much income you should generate through your dividend relative to what you would pay for the stock right now.

Now, let's move on to another W, "when." Dividends don't accrue the way a bond might accrue interest. You have to own the stock on a certain day of the month or the quarter or the year depending on the kind of dividend in order to receive that dividend.

The process works like this. The company sits downs its board of directors and decides to declare a dividend. They will put out a press release. They will say--like Kraft does every so often--we are planning to pay a dividend of $0.29 a share to all of our shareholders.

They will then give out a couple more dates. One is the record date, another is the payment date, but the most important date is actually one that some press releases leave out, called the ex-dividend date. This is two business days before the record date.

This is essentially the day that if you buy the stock on that date, you are no longer eligible for the dividend, but if you bought the stock and held it before the ex-dividend date, then you are eligible, you will get that payout of cash.

And just as a little side note, there is no way to buy the stock right in front of the dividend to get it and then sneak back out. The stock price will automatically adjust downward on the ex-dividend date by the amount of the dividend to reflect the fact that cash has flowed out of the company.

Moving along to W number three, the question "where." Where can I find good dividends? While it is true that many different companies pay dividends, they tend not to be equally distributed across the marketplace. Some types of companies and some kinds of industries tend to favor paying out dividends more than some others whose companies may hold back their earnings in order to finance growth or in some cases, to offset losses.

Examples of sectors where you will find lots of dividends include utilities, packaged foods, pipelines, telephone companies, and many sorts of financial firms. But as I list some of these things, I got to remind you of one thing. Just because a company or an industry might pay a dividend, doesn't mean that the business is good or that the stock is worth owning. You will want to look into the factors that support a company's dividend and whether or not that dividend can grow, which is something that we will leave for a later topic.

Now, for perhaps the biggest question, "Why are dividends are important?" Why do companies pay them? Why should shareholders want to receive them? Companies pay dividends because this is really what corporations are meant to do. Just as somebody who would give their money to a company and invest in it via a bond will expect money back, expect interest payments and then a principal repayment, stocks also carry an implicit promise of future returns of cash to shareholders.

Now, why are dividends important from the standpoint of a shareholder? This is something that's lost on a lot of people when they stare at the minute little changes in the stock market from minute to minute or even the big changes sometimes from minute to minute.

What purpose is say a dividend yield of five%, which would take a whole year to collect, if the stock price can change 5% in a matter of seconds. Well, the fact of the matter is that the 5% that you might get through a dividend yield is much, much more reliable, much more predictable, cash that you can actually take to the bank and use to pay your bills, than the stock market gains that can really come and go.

Now, for the final W, "who." Who should be interested in dividends? Well, naturally, as the editor of a dividend newsletter, I would say "everyone," but I think that there is some truth to back this up. Whether you are investing for growth and you don't expect to tap those funds for any purpose for a number of years into the future, or whether you would need the income right now, dividends are almost always going to be good where you find them.

It is proving that the company is solvent. It has to have cash in order to pay out cash. Management is demonstrating that they are committed to rewarding shareholders directly and those dividends do pile up over time. Again, a stock that might yield 5% today, you might think it will take me 20 years to get my money back, but if the dividend is growing, that's going to produce more of a return. And if you add the dividend into what you are getting from capital appreciation over time, then you are starting to get some real compounding. It pays to think in terms of total return, not just capital gains or dividend yield in isolation.

So, while dividends may not always be in fashion, and here in 2009, most dividend-paying stocks are out of fashion as people are chasing faster and, I would say, riskier gains elsewhere, dividends are the kind of abiding proven investment strategy aspect of an investment strategy that can work so well for individual investors over time.

And if you would be interested in learning more about dividends, how they can work for you, how to look at stocks through the lens of their dividend prospects and for individual recommendations, be sure to check out Morningstar DividendInvestor. You can find more information on Morningstar.com [and Morningstar.co.uk].

Thank you again very much for watching. This has been Josh Peters, Editor of Morningstar DividendInvestor.