This is part 4 of my 5 part series on earning money. Dividend investing is by far the “easiest” way to earn money. To earn money, you don’t have to do anything, but hold quality dividend paying stocks. Of course, nothing is truly that easy. You need to have a fair amount of capital to make enough of an investment to achieve asizeable dividend payout.

But let’s get back to basics. What are dividends and why do companies pay them? Dividends are simply payments made to shareholders. They are usually paid from the profits, but it’s not uncommon for a company that is temporarily (hopefully) unprofitable to continue paying out dividends. Look at Ford. It continues to pay out dividends despite losing billions of dollars. Stopping dividend payments once they’ve started is generally considered a vote of no-confidence. The investment world does not look kindly upon such moves. Dividends should represent excess profits that need not be reinvested in the business. Owners, i.e. shareholders, are entitled to those profits. Small, fast growing companies do not pay dividends because everything is plowed back into the business. This makes sense, as a small company under good management should have a clear growth plan that requires capital.  A mature business is less likely to have obvious areas to grow, and therefore is morelikely to pay out excess in the form of dividends.

Because dividend paying companies tend to be older and mature they are often not as exciting and dynamic as the hot growth companies that tend to make the headlines. Utilities stocks are classic dividend payers. They typically represent stable slow growth companies that have constant and steady cash flow. The other commonly thought of dividend stocks are banks. Banks, in the most simple of worlds, make money by lending money at a higher rate they pay on depositors. They access capital and grow by expanding their depositor base and increasing lending. For that reason, it seems reasonable that a bank does not need to reinvest all its earnings, assuming it has enough capitalization already. I don’t really know enough about it so I’m making it up along the way here.

So, what are typical dividend yields? For example, one stocks I hold is Washington Mutual (WM).  It traded as of Friday May 26, 2007, for $43.26, and pays out quarterly dividends of $.55 for an annual rate of $2.20. $2.20/$43.26 = 5.08%. From the calculation you can see that yield is a function of stock price and dividend payment amounts. As a result, the yield improves one of two ways: the company raises dividends (good), the stock price drops (bad). For example one of my other stock holdings is American Home Mortgage (AHM) which currently yields 20.6% on dividend payments of $4.48 and a stock price of $21.75. The high yield is a function of the low stock price. The market does not have confidence that the company, AHM, a mortgage lender organized as a REIT (Real Estate Investment Trust), will be able to continue to pay dividends at the promised rate. The S&P 500 in aggregate yields about 1.45%.

Looking at the yield of the S&P 500 of 1.45%, dividends do not look particularly attractive when you could be in savings account easily yielding over 5%. The beauty of dividend investing is that neither dividends nor stock prices are static. Dividend payments increase and should at least track inflation if everything else is equal, but more importantly stock prices should increase over time as well. An investor who puts money into dividend paying stocks should not only benefit from the stock appreciation, but also be paid something along the way. For example, even though the S&P 500 is only yielding 1.45% today, had you bought 10 years ago when the S&P 500 was 801 vs today’s 1515 Index value, that dividend yield looks much better. The 1.45% yield off a 1515 price is really 2.7% yield off the 801 price 10 years ago, and more importantly the value of the shares have nearly doubled.

The other benefits of dividends as compared to bond or savings account holdings are taxes. Qualified dividends which are the dividends paid by mostpublicly traded companies qualify for the lower 15% tax rate given to dividends. REITs such as AHM do not qualify. As a result, that 1.45% dividend is equivalent to a 1.85% yield from a savings account given a 30% marginal income tax rate.

There are some investors who swear by dividends not just because of the steady income stream they can provide but because they believe dividends (and especially steadily increasing dividends) are an indicator of quality companies. Quality companies should also see better than average appreciation in share price. Regardless of the validity of this theory, dividend paying shares provide a steady income stream that can be used to either reinvest or as a legitimate part of one’s income.