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Monthly Dividend Stocks Can Provide Solid Income Like all investments, investors should due their due diligence before investing in a monthly dividend stock. A company's dividend yield is important, but the yield is tied to a company's...

By MarketBeat Staff

This story originally appeared on MarketBeat

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These companies provide peace of mind that comes from regular income

Many companies pay dividends on a quarterly or annual basis. However, a select group of companies pay out monthly dividends. For income investors, monthly dividend payments generate a predictable source of income. This provides peace of mind because they don't have to dip into the principal of their investments. Even investors who do not need the benefit of regular income can benefit from re-investing their monthly dividends to buy additional shares.

In this article, we'll review what a dividend is and why companies offer them. We'll also explain why a company may issue a monthly as opposed to a quarterly or annual dividend, and give an example of why investors need to pay attention to more than a company's announced dividend yield.

What are Dividends?

Dividends are payments that a company makes to its shareholders. These payments come out of a company's profit. Companies issue dividends on a regular schedule. Usually this means quarterly payouts. However, there are a select group of companies that pay out on a monthly schedule or on an annual schedule.

Investors can receive the dividends directly as income or they can elect to re-invest their dividend payment to buy additional shares of the company's stock. This ability to receive regular income is the primary reason dividend stocks appeal to income-oriented investors.

This is because many fixed income investors rely on regular income from their investments to help pay the bills. However dividends that pay at quarterly intervals, and bonds that pay out semi-annually, may leave gaps. These gaps can lead investors to dip into the principal of their retirement fund. Aside from creating elaborate dividend calendars, one way these investors can help mitigate avoid these gaps is by having a portion of their dividend investments in stocks that pay monthly dividends.

Why do Companies Pay Dividends?

As stated above, a dividend is paid out of a company's profit before it makes it to the bottom line as retained earnings. A company can reward shareholders in several ways. The most obvious is through stock price appreciation (i.e. capital growth). A second way is by issuing a dividend. In order to pay a dividend, a company needs to be able to have the cash flow needed to support the dividend.

A young, fast-growing company will typically reinvest profit into their business because shareholders expect aggressive growth and are willing to assume the heightened risk that comes with that growth. Companies that are into the mature phase of their business cycle may not be able to deliver the same return for their shareholders by reinvesting their profit into the business.

For this reason, they make the decision to take a portion of their profits and directly pay shareholders as a dividend. This does not mean they won't undertake capital investments or take on debt. It just means that their primary objective is stability, not aggressive growth.

Dividend paying companies are commonly in defensive sectors like utilities and health care. Companies that manufacture consumer staples also fall into this category. Defensive stocks tend to hold their value in any economy. For example, individuals get sick in any economy so pharmaceutical stocks tend to be impervious to recessions. In the same way, consumers still need to pay for electricity, water, and natural gas so these stocks fall into the defensive category.

Why Do Companies Issue Monthly Dividends?

A company that issues a monthly dividend can sustain the cash flow needed to support a monthly dividend. Some of the most popular monthly dividend paying stocks are real estate investment trusts (REITs) and business development corporations (BDCs). These stocks are required to return at least 90% of their profit to investors as a dividend. Many of these companies generate revenue through collecting rent. This is why they have the necessary cash flow to sustain a monthly dividend.

Why Dividend Yield is Not the Best Measure of a Dividend Stock

One of the most common metrics that investors use when comparing the dividend of one company to another is the dividend yield. A dividend yield is a ratio that expresses the company's annual dividend compared to its share price as a percentage. The calculation for dividend yield is:

Annual dividend/Share price

To calculate dividend yield, let's look at this example:

  • Company A announces a $1.75 per share annual dividend. The stock costs $45 per share.
  • Company B announces a $2 per share annual dividend. Their stock also costs $50 per share.

To calculate the yield, you would simply divide the announced per share annual dividend by the share price.

  • For company A, that would be 1.75/40 = 0.043 (4.3%)
  • For company B, that would be 2/50 = 0.04 (4%)

Simply put, investing $10,000 in Company A would produce $752.50 of annual dividend income or $62.70 of monthly dividend income if they pay monthly. That same $10,000 in Company B would produce $800 in annual dividend income or around $66.66 of monthly dividend income. Assuming all other fundamentals were the same, income-oriented investors would prefer to invest in Company B because of the slightly higher payout despite Company A having a higher yield.

This would hold as long as the two companies maintained their current dividend. If Company A in the next month, increases its dividend to $2 and its stock price stays the same, their monthly payout would rise to $71.66 which would make their stock more attractive.

This brings up an important limitation to using dividend yield. A company's dividend yield is tied to its stock price. Stock prices and yields move in opposite directions. Therefore one company may report a higher yield than another company but actually pay less of a dividend. It is also important to look at a company's track record of paying the dividend and whether they are increasing or decreasing the payout.

A more useful measurement for investors is the dividend payout ratio. The dividend payout ratio, which is also known as simply the payout ratio, tells investors how much profit a company is returning to shareholders as a dividend. The formula for the dividend payout ratio is as follows:

  • Dividend Payout Ratio = Dividends Paid/Net Income

What Caution Should Investors Take When Choosing Monthly Dividend Stocks?

Many companies issue monthly dividends with the intention of maximizing shareholder value. However, like any investment, investing in monthly dividend stocks contains risks. Many of these risks can be anticipated if an investor does their due diligence of a company's business.

Of course, investors need to look at a company's history of paying monthly dividends. But past dividend performance does not mean that a company can sustain their monthly dividend. To get a sense of this, investors should look at a company's financial statements including their balance sheet, income statement, cash flow statement and key performance and profitability ratios. These documents will provide information on how much cash a business is generating and how that cash is being deployed.

In addition to making sure that a company has a reliable history of paying dividends, investors need to be aware of any cuts in monthly dividends. Although a company may have many reasons for cutting their dividend, it may mean that the company's performance is slowing to a point where a monthly dividend may eventually become unsustainable. Sometimes, the company may simply need to change to a quarterly or annual dividend schedule. However, in the worst-case scenario, the company may make the decision to stop issuing a dividend altogether.

Some Final Thoughts on Investing in Monthly Dividend Stocks

Monthly dividend stocks provide a service to income investors. This is particularly true for retired investors who need to preserve as much of their principal as possible. With life expectancies increasing, investors need to plan to have their retirement savings last longer than they may originally have expected.

Most income investments, such as bonds do not provide a regular source of income. Bonds will typically make semi-annual payments despite no longer being based on paper coupons as they did in the past. Many stocks pay dividends quarterly, but that is not always helpful to deal with recurring monthly medical expenses and other regular bills. This is where monthly dividend stocks can come in handy.

While investors should not commit the entire income side of their portfolio to monthly dividend stocks, having a reliable stable of these steady performers can help ensure a predictable source of income when bonds and other dividend stocks are not paying out.

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