Do dividend stocks actually beat inflation?
Dividend investors have seen dividends encompass about 40% of all stock market returns since 1930, according to Fidelity. Stocks such as the Dividend Kings or Dividend Aristocrats, which increased their dividends the most, outperformed the broad market. The Dividend Kings and Aristocrats are stocks that have paid out (and raised) their dividends for more than 50 and 25 years, respectively.
Incidentally, inflation has hit its highest rate in 30 years. Does that mean it's a good time to invest in dividend-paying stocks? Let's find out.
What is Inflation?
Inflation is the increase in prices of goods and services over a given period of time. Inflation may also refer to the overall increase in the cost of living as well.
The annual inflation rate for the 12 months ended April 2022 is currently 8.3% in the United States, after rising 8.5% previously, according to the U.S. Labor Department. The U.S. Inflation Calculator has also published historical inflation rates from 1914 to 2022, calculated using the Consumer Price Index published monthly by the Bureau of Labor Statistics (BLS.
Periods of inflation can help motivate you to invest in the right vehicles, but it's important to do your homework. Look for strong balance sheets, free cash flow and management teams committed to investors. We'll walk through more information about how to make these determinations later on in the article.
What Are Dividends?
What are dividends, exactly? When you purchase a stock share, a publicly traded company may produce profits and then return some of those profits to you. Receiving dividends is one of the perks of investing in dividend-paying companies. It's like a regular paycheck you can receive as a "reward" for your investments.
Can Dividend Stocks Beat Inflation?
You can make money in chiefly two ways: through capital appreciation and dividends in the stock market. Dividend payouts usually occur on a quarterly basis, though they can also happen on an annually or semiannually basis and sometimes on a monthly basis. For example, let's say a company offers dividend payouts of $1 per share on a quarterly basis. This means that a company will pay out dividends four times per year for a total of $4 per share on an annual basis.
Solid, reputable companies often raise their dividend payouts as a hedge against inflation. Regularly scheduled payments can help reduce stock volatility. Let's say that for the next year, the company we mentioned above decides to raise its dividend $0.50, which means that you'd receive $1.50 per share on a quarterly basis. This means that you'd receive dividends four times per year for a total of $6 per share on an annual basis. The fact that a company can pay out dividends to its shareholders is a good indicator of a company's quality track record.
What can dividend stocks offer as a way to beat inflation? Here are a few things:
- Outperformance: Certain dividend payers, such as the Dividend Aristocrats, can outperform S&P 500 value stocks by a significant margin.
- Less volatility: Dividend stocks often show proof of lower volatility than growth and value stocks.
- Specific sector performance: During inflationary times, looking for stocks that can pass on rising costs to consumers. Doing so can net you a benefit as an investor. For example, the rising costs of fuel for a company that relies heavily on diesel may be passed on to consumers instead of the company itself.
How to Purchase Dividend Stocks to Beat Inflation
So, how do you purchase dividend stocks to beat inflation? It's a good idea to do a lot of research before you decide on the best dividend stocks that fit your needs.
Step 1: Understand your investing goals.
First and foremost, it's important that you understand your personal investment goals. Are you saving for retirement (when beating inflation over a large period of time might be imperative) or are you aiming to save over, say, four years, in order to pay for a dream vacation? Getting a sense of your investment goals can help steer your path and plans for your future. It's best not to dive unplanned into investing if you're not sure about your specific goals.
It's understandable that that might seem difficult. After all, it may seem overly ambitious to map out your entire life. However, getting a rough understanding of how you might want to save for your future can help guide your investment decisions.
Step 2: Check companies' track records.
It's worth diving into the company's underlying fundamentals, such as the dividend yield, dividend payout ratio, dividend coverage ratio, free cash flow to equity (FCFE) and more. Let's go over what each of these means.
- Dividend yield: Dividend yield shows how much a company pays out annually in dividends per dollar you invest, expressed as a percentage. You can determine dividend yield by dividing the annual dividend payment by the stock price of a company. For example, let's say a company paid out an annual dividend of $4 and traded at $100 per share. $4/$100 = 4%. A high dividend yield could mean that the company may be experiencing underlying issues.
- Dividend payout ratio: The dividend payout ratio is the total amount of dividends paid out to shareholders relative to the net income of the company, or the percentage of earnings paid to shareholders via dividends. The formula looks like this: Yearly Dividend per Share / Earnings per Share (EPS). Try to invest in dividend stocks with a payout ratio below 60%.
- Dividend coverage ratio (DCR): The dividend coverage ratio measures the number of times that a company can pay dividends to its shareholders. The formula is Net Income / Dividend Declared, where net income is the earnings after all expenses are paid (including taxes) and the dividend declared is the amount of dividend shareholders receive. Look for a DCR above 2. A DCR below 1.5 may mean that some issues are plaguing the company.
- Free cash flow to equity (FCFE): Free cash flow to equity (FCFE) is the amount of cash a corporation generates that can be distributed to shareholders. It's calculated like this: Free Cash Flow to Equity (FCFE) = Net Income - (Capital Expenditures - Depreciation) - (Change in Non-Cash Working Capital) + (New Debt Issued - Debt Repayments). You can find most of this information on a company's cash flow statement. It's a good way to determine the value of a company. If FCFE is less than the dividend payment and the cost to buy back shares, it might be a red flag.
It might seem intimidating to tackle these types of fundamental questions, but many websites offer information, including companies' balance sheets. Do your best to dig into these questions.
Step 3: Choose stocks for your portfolio.
You can gain exposure to dividend payers in several ways:
- Individual stocks: Choosing individual stocks can offer big boosts for your portfolio, but it's important to diversify in other ways. You may not want to sink an entire $50,000 investment into one stock — you could lose all your money. Learn more about how often a dividend payer pays out dividends, the payout ratio (detailed above) and the cash flow. You can also consider purchasing a large number of individual stocks in order to diversify. Consider investing across a number of sectors instead of putting all your money into a single sector. For example, this might mean investing in the consumer staples and technology, energy and materials sectors.
- Exchange-traded funds (ETFs) and index funds: You can invest in dividends passively! If you want to track an index, consider moving toward ETFs and index funds. Doing so gives you automatic diversification, with the benefit of tracking a benchmark index. Learn more: 8 Best Dividend Stock ETFs and How to Invest in Them. You may have a robo-advisor or human advisor help you choose your funds.
- Actively managed funds: Investing in actively managed funds means that an investment advisor or professional portfolio manager chooses investments for you. In this case, your investments don't actively track an index. Portfolio managers will buy and sell based on what they believe the market will do.
Step 4: Invest.
Finally, invest with a brokerage! Navigate to the ticker symbol and enter the number of shares you plan to purchase. Choose either market order, limit order, stop order or stop-limit order. Market order means that you buy right now at the best available price. A limit order means you buy at a designated price (or lower). A stop order means you'll buy after a specified price (the stop price) has been reached. Finally, a stop-limit order means that once the stop price has been reached, the trade turns into a limit order and is filled to the point where specified price limits can be met.
Invest with Inflation in Mind
Though inflation is top-of-mind right now (can you believe how much it costs to buy a dozen eggs?) it's always a good idea to have a plan for how to handle inflation over a long period of time. Inflation will continue to rise over the course of time. By the time you retire, you might be shocked to compare today's "cheap" cost of eggs to the cost of eggs in 40 years!
Having an inflation plan is a solid way to pave the way for financial independence. Solid dividend-paying stocks can be one of the best ways to preserve your wealth for the future.