Healthy wealth

Thursday, May 31, 2018

Learn How to Become Rich

Truths That Can Help Set You on the Path to Financial FREEDOM!

How to Become Wealthy — •••If you want to become wealthy, there are nine truths and behaviors that can help you on your investment journey.

Building wealth can be one of the most exciting and rewarding undertakings in a person's life. Aside from providing a more comfortable day-to-day experience, a substantial net worth can reduce stress and anxiety as it frees you from worrying about putting food on the table or being able to pay your bills. For some, that alone is enough motivation to start the financial journey. For others, it's more like a game; the passion beginning when they receive their first dividend check from a stock they own, interest deposit from a bond they acquired, or rent check from a tenant living in their property.

While the thousands of articles I've written over the years are geared to helping you learn how to become wealthy, I wanted focus on the philosophical aspect of the task by sharing with you five truths that can help you better understand the nature of the challenge you face as you set to the task of accumulating surplus capital.

1. Change the Way You Think About Money

The general population has a love / hate relationship with wealth. Some resent those who have money while simultaneously hoping for it themselves. Yet, absent some fairly specific exceptions, in a prosperous and free society, the reason a vast majority of people never accumulate a substantial nest egg is because they don't understand the nature of money or how it works. This is, in part, one of the reasons that the children and grandchildren of the wealthy have a so-called "glass floor" beneath them. They are gifted knowledge and networks that allow them to make better long-term decisions without even realizing it.

A fascinating example comes from the field of behavioral economics and involves first-generation college graduates accumulating lower levels of net worth for every dollar in salary income due to not knowing about basic concepts such as how to take advantage of 401(k) matching.

The bigger principal here is that capital, like a person, is a living thing.

When you wake up in the morning and go to work, you are selling a product - yourself (or more specifically, your labor). When you realize that every morning your assets wake up and have the same potential to work as you do, you unlock a powerful key in your life. Each dollar you save is like an employee. Over the course of time, the goal is to make your employees work hard, and eventually, they will make enough money to hire more workers (cash). When you have become truly successful, you no longer have to sell your own labor, but can live off of the labor of your assets. In my own life, my entire career has been built on getting out of bed in the morning and trying to create or acquire cash-generating assets that will produce more and more funds for me to redeploy into other investments.

2. Develop an Understanding of the Power of Small Amounts

The biggest mistake most people make when trying to figure out how to get wealthy is that they think they have to start with an entire Napoleon-like army of funds at their disposal. They suffer from the "not enough" mentality; namely that if they aren't making $1,000 or $5,000 investments at a time, they will never become rich. What these people don't realize is that entire armies are built one soldier at a time; so too is their financial arsenal.

A family member of mine once knew a woman who worked as a dishwasher and made her purses out of used liquid detergent bottles. This woman invested and saved everything she had despite it never being more than a few dollars at a time. Now, her portfolio is worth millions upon millions of dollars, all of which was built upon small investments. I am not suggesting you become that frugal, but the lesson is still a valuable one. That lesson: Do not despise the day of small beginnings!

3. With Each Dollar You Save, You Are Buying Yourself Freedom

When you put it in these terms, you see how spending $20 here and $40 there can make a huge difference in the long run. Given that money has the ability to work in your place, the more of it you employ, the faster and larger it has a chance to grow. Along with more money comes more freedom - the freedom to stay home with your kids, the freedom to retire and travel around the world, or the freedom to quit your job.

If you have any source of income, it is possible for you to start building wealth today. It may only be $5 or $10 at a time, but each of those investments is a stone in the foundation of your financial freedom.

4. You Are Responsible for Where You Are in Your Life

Years ago, a friend told me she didn't want to invest in stocks because she "didn't want to wait ten years to be rich..." she would rather enjoy her money now. The folly with this type of thinking is that the odds are, you are going to be alive in ten years. The question is whether or not you will be better off when you arrive there. Where you are right now is the sum total of the decisions you have made in the past. Why not set the stage for your life in the future right now?

These aren't empty feel-good words or admonishments. I'm going to repeat it again: Where you are right now is the sum total of the decisions you have made in the past. Your life reflects how you spend your time and your money. Those two inputs are your destiny.

5. Consider Becoming an Owner of Things You Understand as a First Step to Building Wealth

One of the big intellectual and emotional hangups people seem to have when they aren't exposed to wealth or wealthy families is making the connection between productive assets and their every day life. They don't understand, on a visceral level, that if they own shares of a company such as Diageo, every time someone takes a drink of Johnnie Walker or Captain Morgan, a portion of that money is making its way back to the corporate coffers for ultimate distribution to them in the form of a dividend. They don't truly understand that if they stand outside the gates at Disneyland and watch people walk into the park, if they own The Walt Disney Company, they enjoy their share of any profits generated from those guests.

Rich men and women have a habit of using a disproportionate percentage of their income to acquire productive assets that cause their friends, family members, colleagues, and fellow citizens to constantly shovel money into their pockets. Consider, as you read this, that you've probably never met me. Yet, if you've ever eaten a Hershey's bar or a Reese's peanut butter cup, you've indirectly sent me real cash. If you've ever taken a sip of a Coca-Cola or eaten a Big Mac, you've indirectly sent me real cash. If you've ever taken out a student loan or borrowed money to buy a house from a bank like Wells Fargo, you've indirectly sent me real cash. If you've ever ordered a cup of coffee at Starbucks, you've indirectly sent me real cash. If you've ever purchased Colgate toothpaste or used Listerine mouth wash, swiped a Visa or MasterCard or filled up your car with gasoline from an Exxon Mobil station, you've indirectly sent me real cash. I wasn't gifted those ownership stakes. I didn't inherit those ownership stakes. I started with nothing and made a decision that my highest, and first, financial priority was to acquire ownership of productive assets early in life. It was a matter of priorities. By respecting every dollar that flowed through my hands, and making a conscious, informed decision about how I wanted to put it to work, the miracle of compounding did the heavy lifting.

When you understand this, you understand that, in societies such as the United States where the trend for several centuries has been lower and lower rates of millionaires and billionaires being made up of first-generation, self-made rich, building wealth is often the by-product of behavioral patterns that are conducive to building wealth. It's basic mathematics. Replicate the behavior and net worth tends to accumulate.

The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.

#6: Study and Admire Success and Those Who Have Achieved It... Then Emulate It

A very wise investor once said to pick the traits you admire and dislike the most about your heroes, then do everything in your power to develop the traits you like and reject the ones you don't. Mold yourself into who you want to become. You'll find that by investing in yourself first, money will begin to flow into your life.

Success and wealth beget success and wealth. You have to purchase your way into that cycle, and you do so by building your army one soldier at a time and putting your money to work for you.

#7: Realize that More Money is Not the Answer

More money is not going to solve your problem. Money is a magnifying glass; it will accelerate and bring to light your true habits. If you are not capable of handling a job paying $18,000 a year, the worst possible thing that could happen to you is for you to earn six figures. It would destroy you. I have met too many people earning $100,000 a year who are living from paycheck to paycheck and don't understand why it is happening. The problem isn't the size of their checkbook, it is the way in which they were taught to use money.

#8: Unless Your Parents Were Wealthy, Don't Do What They Did

The definition of insanity is doing the same thing over and over again and expecting a different result.

If your parents were not living the life you want to live then don't do what they did! You must break away from the mentality of past generations if you want to have a different lifestyle than they had.

To achieve the financial freedom and success that your family may or may not have had, you have to do two things.

First, make a firm commitment to get out of debt. To find out which debts should be paid off before you invest and those that are acceptable, read Pay Off Your Debt or Invest?. Second, make saving and investing the highest financial priority in your life; one technique is to pay yourself first.

Purchasing equity is vital to your financial success as an individual whether you are in need of cash income or desire long-term appreciation in stock value. Nowhere else can your money do as much for you as when you use it to invest in a business that has wonderful long-term prospects.

#9: Don't Worry

The miracle of life is that it doesn't matter so much where you are, it matters where you are going. Once you have made the choice to take control back of your life by building up your net worth, don't give a second thought to the "what ifs". Every moment that goes by, you are growing closer and closer to your ultimate goal - control and freedom.
Every dollar that passes through your hands is a seed to your financial future. Rest assured, if you are diligent and responsible, financial prosperity is an inevitability. The day will come when you make your last payment on your car, your house, or whatever else it is you owe.

Until then, enjoy the process.

Wednesday, May 30, 2018

The Balance

Building a Complete Financial Portfolio

Steps to Building a Complete Financial Portfolio

You have a dream about your life. You know where you want to live, what you want to drive, and the type of clothes you want to wear. Have you ever stopped to calculate exactly what it would cost you, in financial terms, to achieve that desired lifestyle? If you're like most people, the answer is no.

This step-by-step guide empowers you to take action by building a complete financial portfolio. What is a complete financial portfolio? It is a term I use to define an individual who has fully-funded retirement accounts, is debt-free, has a six-month emergency cash reserve, owns diversified investments across different asset classes, and invests in themselves.

01
Before you Begin Building your Complete Financial Portfolio

Sit down, take out a pen, and make a list of everything you own (e.g., assets such as cars, stocks, bonds, mutual funds, cash, bank accounts) and everything you owe (e.g., liabilities such as student loans, credit card balances.)
Be brutally honest - don't keep something off the list because you'll "get to it tomorrow", or "it isn't a problem." The key to changing your life is to determine exactly where you stand in this moment in time.

This balance sheet is going to be extremely important as we craft our way through the following steps. It's a picture in time, the first step in understanding your net worth, it's a benchmark as you build your financial future.

Commit to Change

The process of building a complete financial portfolio can take years. If you are dedicated and diligent, you will reach your goal, so don't lose hope!

Contribute to Your 401k with Your Employer's Matching Funds

In 401k Retirement Plan: Begin Building for Your Future, you learned that many businesses match contributions employees make to their 401k accounts. The amount of these matching contributions can vary widely from company to company; most providing an escalation in benefits based upon tenure.
Yet, despite this free cash, some individuals do not take advantage either because they don’t understand the time value of money or don’t believe they can afford to have their take-home pay reduced.

The fact is you can’t afford not to contribute. If your employer matches $1-for-$1 up to the first 5% of your contribution, you are immediately earning a 100% return on your investment. There is no investment in the world that can guarantee returns even close to that amount.

When you consider these funds will also grow tax-deferred in your 401k for the next twenty, thirty, or forty years, the opportunity cost over a career can be millions of dollars!

The bottom line: even if you are buried under a mountain of credit card debt, can’t pay your monthly bills, and have your telephone disconnected, you must contribute to your 401k up to the amount of your employer’s match. If your employer doesn’t match, don’t contribute anything until you’ve completed the next several steps.

Pay Off High-Interest Credit Card Debt

women paying bills with huge credit card.

The next step in building your complete financial portfolio is to develop a plan for paying down high-interest credit card debt.

Take the balance sheet you prepared and, on a separate sheet of paper, rank all of your debts by the interest rate you are paying; highest first.
Decide how much you can afford to dedicate to debt reduction each month from your regular income. If you are making regular contributions to a mutual fund or investment account outside of your 401k match, temporarily stop and add that money to your “debt-reduction” funds.
Pay the minimum balance on all of the debts except the highest-ranked on the list (i.e., the card with the highest interest rate.) The highest ranked card should receive all of the capital (less the minimums on the other debts) you can afford to part with until it has been completely paid off.
When you’ve wiped out a balance, cross the card off your list and put it in a drawer (do not cancel the card; this will lower your credit score and cause the interest rate you pay on the variable rate and new debt to increase!) Do not charge to it again.
Continue this process until all of these accounts are paid-in-full.

The process may take months or even years. The key is to avoid making new charges and find extra money to pay down debt faster. This doesn’t mean you have to abandon your cards altogether; they are not inherently evil. In fact, credit cards can be a valuable financial tool if used responsibly.

Open and Fully Fund a Roth IRA

an egg in a nest with ROTH printed on it, sitting on top of money

The Roth IRA is, in my opinion, the greatest financial account available to investors in the United States. The odds are good you qualify; as long as your annual income does not exceed $95,000 (single) or $150,000 (married), you can open a Roth IRA.
Contributions (subject to annual limits) are made with after-tax dollars. All Roth IRA contributions can be withdrawn at any time without any penalty. Once you reach the age of 59 1/2 (subject to the five-year rule), all withdrawals are absolutely, 100% tax-free.
In other words, if you purchased $10,000 worth of the next-Microsoft through your Roth IRA and held it for twenty years, selling the stake at retirement for $5 million, you would owe Uncle Sam nothing.

Additional Benefits of a Roth IRA

No mandatory distribution age
Roth IRA contributions can be used to purchase a variety of investments (stocks, bonds, certificates of deposits, etc.)
If you’ve been unemployed for longer than twelve weeks, you can use Roth IRA funds to pay medical insurance premiums without penalty
Certain higher education costs for you, your spouse, and your immediate family can be funded through your Roth IRA
Medical expenses in excess of 7.5% of your gross adjusted income can be paid for, without penalty, by your Roth IRA.

You can open a Roth IRA at any bank or brokerage firm. Read the following articles a list of IRA contribution limits and additional benefits.

05
Purchase a Home

Family unpacking moving boxes in living room

The next step to constructing a complete financial portfolio is to save for a down payment on a house. By owning your own home, you are converting what was previously an expense (rent) into equity.
To sweeten the deal, not only is the interest paid on your mortgage tax-deductible, but you are permitted a lifetime capital gains tax exemption of $250,000 (single) or $500,000 (married) if you sell your home at a profit.

From an investment standpoint, this is particularly attractive. As financial guru Suze Orman frequently reminds her fans, most homes appreciate at 3-4% per year and are purchased with 20% down.

A $100,000 house, for example, would appreciate $3,000 to $4,000 per year, or nearly 20% on the $20,000 cash investment (the down payment.) There is no other investment in the world that is practical, generates a comparable return and diversifies one’s asset allocation into real estate at the same time.

Additional Costs of Becoming a Homeowner

The costs of becoming a homeowner are significantly more than the basic mortgage payment. Costs that you need to consider include:

Private mortgage insurance (for down payments less than 20% of the property value)
Homeowner insurance
Utility bills
Home repairs (broken furnace, appliances, etc.)
Lawn care (if you’re living outside of a major city)
Property tax

Build a Six-Month Emergency Reserve

Now that you are a homeowner, it is more important than ever that you establish a six-month emergency cash reserve to cover basic living expenses. This will allow you to weather any unexpected storms including home repairs, unemployment, and medical bills. At the very least, the emergency cash reserve should be sufficient to cover up to six months of the following:

Mortgage payments
Insurance costs
Utility bills
Groceries
Fixed payments (car payments, student loan payments, etc.)
Minimum payment on credit cards

Investing Your Emergency Cash Reserve

The primary investment objective for your emergency cash reserve is safety, not return. The simplest option is to park the funds into savings or a money market account. If you are interested in generating extra income, consider building a laddered certificate of deposit portfolio.

Building a Laddered Emergency Cash Reserve

Assume your emergency cash reserve is $12,000. You would go to your local bank and open six certificates of deposits (CD's) as follows:

$2,000 30 day (1 month) maturity
$2,000 60 day (2 month) maturity
$2,000 90 day (3 month) maturity
$2,000 120 day (4 month) maturity
$2,000 150 day (5 month) maturity
$2,000 180 day (6 month) maturity

As each certificate of deposit matures, roll it over into a new six-month CD. In short order, you will own six separate six-month CD's, one of which will mature every month.

07
Pursue Other Investment Opportunities

Great work! If you’ve followed the step-by-step for building a complete financial portfolio, you have contributed to your 401k, paid off your credit card debt, fully funded a Roth IRA, purchased a home, and established a six-month emergency fund. Now, it’s time to turn your eyes to additional investment opportunities by opening a brokerage account.

The Range of Investments Available

A brokerage account will allow you to invest in stocks, bonds, mutual funds, certificates of deposit, real estate (via REITs), treasuries, and more. Selecting a broker is largely a question of what you want: are you looking for a relationship with a single person whom you can call (i.e., a traditional broker), or do you want to place most of your trades online or with a broker you do not know (i.e., with a discount broker.)

The primary benefit of the latter model is significantly lower trading costs. Many brokerage firms offer both models and allow the client to choose at the time they open their account. For help making the right decision, take a look at the article Before You Open a Brokerage Account.

08
Invest in Yourself

Couple signing documents — •••If you’re thinking about starting a business, improving your professional skills, or making yourself stand out with your employer, you may want to consider investing in yourself by taking educational courses.

Many colleges and universities offer professional certification programs such as NYU’s School of Continuing and Professional Studies; certificates available include Financial Analysis, Accounting, Bookkeeping, Portfolio Management, French, German, Italian, International Affairs, Web Development, Marketing, Property Management, Real Estate Finance and Investment, Cinematography, Product Design and more. Some courses and certification programs are available online.
As the investing for beginners guide, I'm often asked advice for someone starting out on their own. The answer is almost invariably: enroll in basic accounting and finance courses. Although the cost may be several thousand dollars, the knowledge you gain can make a significant difference in your income if applied wisely; paying for itself many, many times over.

09
Save for Your Childrens' Education

Parents and child talking to a businesswoman

Perhaps the best solution is to wait until after graduation – evaluate the academic performance, the professional drive, and the qualitative characters objectively.
If you like what you see, offer to pay for all or a portion of the education. That way, if little John takes seven years to graduate because he’s spending all of his free time at frat parties, he can bear the consequences while you enjoy your new Mercedes.

Retirement First

Regardless of your opinion on the matter, it is vital that you save for your retirement before you put funds aside for your child’s education. If you are short on cash when it is time for the kids to go to college, there are numerous low-interest, highly-favorable loan options available in addition to scholarships, grants, and Federal aid; if you arrive with empty pockets at retirement, however, there is no one there to help fund your lifestyle.

Investing Education Assets for Financial Aid

Financial aid calculations are more favorable when assets are held in the parents’ name, rather than the child's.

10
Stay the Course

Congratulations! The hard work is done – you’ve laid the foundation. The key to success is making intelligent decisions and sticking to the basics of the complete financial portfolio. There is nothing magical about wealth building; it is achieved through a culmination of small, disciplined, choices. To borrow a line from the important book The Richest Man in Babylon, you must keep your mind on the bigger goal to “protect your true wants from your casual desires.”

Dividends Work

The Beginner's Step-By-Step Overview of How Dividends Work

Have you ever wondered what it would be like to sit at home, reading by the pool, living off dividend checks that arrive regularly through the mail? This common dream can become a reality, but before you can even hope to achieve that level of financial independence, you must understand what dividends are, how companies pay dividends, and the different types of dividends that are available such as cash dividends, property dividends, stock dividends, and liquidating dividends, just to name a few.

That's why I put together this step-by-step Dividends 101 resource. It will walk you through the basics, ensuring that you have a solid foundation before diving into the more practical content in our Ultimate Guide to Dividends and Dividend Investing. By starting here, you'll learn to avoid tax traps such as buying dividend stocks between the ex-dividend date and the distribution date, effectively forcing you to pay other investors' income taxes! You'll also learn why some companies refuse to pay dividends while others pay substantially more, how to calculate dividend yield, and how to use dividend payout ratios to estimate the maximum sustainable growth rate.

Clear off your desk, grab a pen and notepad, and pour a cup of coffee (or tea if you prefer). You're about to embark on a journey that will put you years ahead of other new investors on understanding dividends and the important role they play in your investment portfolio.

01
How a Company Pays Dividends and the Three Dividend Dates that Matter to You

•••Before a company can pay cash dividends to shareholders, it has to go through a legal checklist that includes declaring a declaration date, ex-dividend date, date of record, and distribution date. As an investor, you need to know what these represent. kyoshino/Getty Images

Companies that earn a profit can do one of three things: pay that profit out to shareholders, reinvest it in the business through expansion, debt reduction or share repurchases, or both. When a portion of the profit is paid out to shareholders, the payment is known as a dividend. For many investors, "living off dividends" is the ultimate goal (for more information about this, you can read the 10 Part Guide to Income Investing).

During the first part of the twentieth century, dividends were the primary reason investors purchased stock. It was literally said on Wall Street, “the purpose of a company is to pay dividends”. Today, the investor’s view is a bit more refined; it could be stated, instead, as, “the purpose of a company is to increase my wealth.” Indeed, today’s investor looks to dividends and capital gains as a source of increase. Microsoft, for example, did not pay a dividend until it had already become a $350 billion company, long after making the company’s founders and long-term shareholders multi-millionaires or billionaires.

The Process

Dividends must be declared (i.e., approved) by a company’s Board of Directors each time they are paid. There are three important dates to remember regarding dividends.

Declaration date: The declaration date is the day the Board of Directors announces their intention to pay a dividend. On this day, the company creates a liability on its books; it now owes the money to the stockholders. On the declaration date, the Board will also announce a date of record and a payment date.
Date of record: This date is also known as “ex-dividend” date. It is the day upon which the stockholders of record are entitled to the upcoming dividend payment. According to Barron’s, a stock will usually begin trading ex-dividend or ex-rights the fourth business day before the payment date. In other words, only the owners of the shares on or before that date will receive the dividend. If you purchased shares of Coca-Cola after the ex-dividend date, you would not receive its upcoming dividend payment; the investor from whom you purchased your shares would.
Payment date: This is the date the dividend will actually be given to the shareholders of the company.

A vast majority of dividends are paid four times a year on a quarterly basis. This means that when an investor sees that, for example, Coca-Cola pays an $0.88 dividend, he will actually receive $0.22 per share four times a year. Some companies, such as McDonald’s, pay dividends on an annual basis.

02

Cash Dividends, Property Dividends, and Special One-Time Dividends

Cash Dividends

Regular cash dividends are those paid out of a company’s profits to the owners of the business (i.e., the shareholders). A company that has preferred stock issued must make the dividend payment on those shares before a single penny can be paid out to the common stockholders. The preferred stock dividend is usually set whereas the common stock dividend is determined at the sole discretion of the Board of Directors (for reasons discussed later, most companies are hesitant to increase or decrease the dividend on their common stock). You can find a detailed discussion of preferred stock and its dividend provisions in The Many Flavors of Preferred Stock: A Possible Investment for Your Fixed Income Portfolio.

Property Dividends

A property dividend is when a company distributes property to shareholders instead of cash or stock. Property dividends can literally take the form of railroad cars, cocoa beans, pencils, gold, silver, salad dressing or any other item with tangible value. Property dividends are recorded at market value on the declaration date.

Special One-Time Dividends

In addition to regular dividends, there are times a company may pay a special one-time dividend. These are rare and can occur for a variety of reasons such as a major litigation win, the sale of a business, or liquidation of an investment. They can take the form of cash, stock, or property dividends. Due to the temporarily lower rates of taxation on dividends, there has been an increase in special dividends paid in recent years.

To add sugar to spice, there are times when these, special one-time dividends are classified as a “return of capital”. In essence, these payments are not a payout of the company’s profits but instead a return of money shareholders have invested in the business. As a result, return of capital dividends are tax-free.

Special one-time dividends sometimes offer an opportunity for arbitrage.

03
Stock Dividends and How They are Different From Stock Splits

Stock Dividends

A stock dividend is a pro-rata distribution of additional shares of a company’s stock to owners of the common stock. A company may opt for stock dividends for a number of reasons including inadequate cash on hand or a desire to lower the price of the stock on a per-share basis to prompt more trading and increase liquidity (i.e., how fast an investor can turn his holdings into cash). Why does lowering the price of the stock increase liquidity? On the whole, people are more likely to buy and sell a $50 stock than a $5,000 stock; this usually results in a large number of shares trading hands each day.

A Practical Example of Stock Dividends:

Company ABC has 1 million shares of common stock. The company has five investors who each own 200,000 shares. The stock currently trades at $100 per share, giving the business a market capitalization of $100 million.

Management decides to issue a 20% stock dividend. It prints up an additional 200,000 shares of common stock (20% of 1 million) and sends these to the shareholders based on their current ownership. All of the investors own 200,000, or 1/5 of the company, so they each receive 40,000 of the new shares (1/5 of the 200,000 new shares issued).

Now, the company has 1.2 million shares outstanding; each investor owns 240,000 shares of common stock. The 20% dilution in value of each share, however, results in the stock price falling to $83.33. Here’s the important part: the company (and our investors) are still in the exact same position. Instead of owning 200,000 shares at $100, they now own 240,000 shares at $83.33. The company’s market capitalization is still $100 million.

A stock split is, in essence, a very large stock dividend. In cases of stock splits, a company may double, triple or quadruple the number of shares outstanding. The value of each share is merely lowered; economic reality does not change at all. It is, therefore, completely irrational for investors to get excited over stock splits. If you do not still fully understand this, you must read How to Think About Share Price. It will clear up any lingering confusion.

One of the more interesting theories of corporate dividend policy is that managements should opt for stock dividends over all other kinds. This will allow investors that want their earnings retained in the business (and not taxed) to hold on to the additional stock paid out to them. Investors that want current income, on the other hand, can sell the shares they receive from the stock dividend, pay the tax and pocket the cash - in essence, creating a “do-it-yourself” dividend.

04 Corporate Dividend Policy, Dividend Payout Ratio, and Dividend Yield

Whether or not high dividends are good or bad depends upon your personality, financial circumstances, and the business itself.

In Determining Dividend Payout: When Should Companies Pay Dividends?, you learned that, “a company should only pay dividends if it is unable to reinvest its cash at a higher rate than the shareholders (owners) of the business would be able to if the money was in their hands. If company ABC is earning 25% on equity with no debt, management should retain all of the earnings because the average investor probably won't find another company or investment that is yielding that kind of return.”
At the same time, an investor may require cash income for living expenses. In these cases, he is not interested in long-term appreciation of shares; he wants a check with which he can pay the bills.

Dividend Payout Ratio

The percentage of net income that is paid out in the form of a dividend is known as the dividend payout ratio. This ratio is important in projecting the growth of company because its inverse, the retention ratio (the amount not paid out to shareholders in the form of dividends), can help project a company’s growth.

Calculating Dividend Payout Ratio

In 2003, Coca-Cola's cash flow statement showed that the company paid $2.166 billion in dividends to shareholders. The income statement for the same year showed the business had reported a net income of $4.347 billion. To calculate the dividend payout ratio, the investor would do the following:

$2,166,000,000 dividends paid
---------(divided by)---------
$4,347,000,000 reported net income

The answer, 49.8%, tells the investor that Coca-Cola paid out nearly fifty percent of its profit to shareholders over the course of the year.

Dividend Yield

The dividend yield tells the investor how much he is earning on a common stock from the dividend alone based on the current market price. Dividend yield is calculated by dividing the actual or indicated annual dividend by the current price per share.

For sake of illustration, let's say The Washington Post pays an annual dividend of $7 and trades at $910 per share; Altria Group (formerly Philip Morris) pays an annual dividend of $2.72 and trades at $49.75 per share. By calculating dividend yield, the investor can compare the amount he would earn in cash income annually from each security.

Washington Post Dividend Yield Calculation
$7.00
----(divided by)----
$910
= 0.0077 or 0.77%
Altria Group Dividend Yield Calculation
$2.72
----(divided by)----
$49.75
= 0.055 or 5.5%

In other words, despite the fact that the Washington Post pays a higher per-share dividend, $100,000 invested in its common stock would yield only $770 in annual income as opposed to the same amount invested in Altria Group which would yield $5,500. An investor interested in dividend income and not capital gains should opt for the latter, all else being equal.

05 The Dividend Tax Debate

•••The IRS taxes dividends twice: Once when the company earns the money, and again when paid out to stockholders! In other countries, companies get a tax deduction to encourage managements to reward owners instead of building empires on their dime. H. Armstrong Roberts/ClassicStock/Getty Images

Dividends, like interest, are taxed at a person’s individual tax rate. Capital gain taxes, on the other hand, are assessed according to the length of time an investor held his investment and can be as low as half the rate levied on dividends income. This difference in tax treatment is another reason many investors opt for long-term equity holdings that reinvest capital into the business instead of paying it out in the form of a dividend; by avoiding the double-taxation, they can compound their wealth at a faster rate.

There is a significant dividend tax, or double taxation, political controversy. The corporation paid income taxes on the profit it earned (original tax). The owners of the business then take that profit out for their personal use in the form of a dividend and are taxed at personal income tax rates (second tax). In effect, they have paid the government twice.

The proponents of the dividend tax argue that the wealthy, by definition, own significantly more investments than the poor. Therefore, it would be possible for someone to earn billions of dollars in dividend income and not pay a dime in Federal taxes. This, they say, is inherently unfair. The gap between the rich and the poor would explode overnight.

For more information, read The Investor's Guide to the Dividend Tax - What the Dividend Tax Is and the Dividend Tax Rates. You may also want to read Dividend Tax - The Political Debate: Understanding the Double Taxation Fuss.

06
Selecting High Dividend Stocks

•••Selecting high dividend paying stocks is an art and science. By putting together a portfolio of dividend stocks, you can use the regular income to spend or to grow your business. Sam Edwards/Getty Images

Selecting High Dividend Stocks

An investor desiring to put together a portfolio that generates high dividend income should place great scrutiny on a company’s dividend payment history. Only those corporations with a continuous record of steadily increasing dividends over the past twenty years or longer should be considered for inclusion.

Furthermore, the investor should be convinced the company can continue to generate the cash flow necessary to make the dividend payments; a handgun manufacturer, for example, may have a long history of high dividend payments while generating strong cash flow from operations yet not make a good investment because it faces litigation which, if successful, will bankrupt the business.

Dividends Related to Cash Flow - Not Reported Earnings

This brings up an important point: dividends are dependent upon cash flow, not reported earnings. Almost any Board of Directors would still declare and pay a dividend if cash flow was strong but the company reported a net loss on a GAAP basis. The reason is simple: investors that prefer high dividend stocks look for stability. A company that lowers its dividend is probably going to experience a decline in stock price as jittery investors take their money elsewhere. Companies will not raise the dividend rate because of one successful year. Instead, they will wait until the business is capable of generating the cash to maintain the higher dividend payment forever. Likewise, they will not lower the dividend if they think the company is facing a temporary problem.

Debt Restrictions

Many companies are not able to pay dividends because bank loans, lines of credit, or other kinds of debt financing place strict limitations on the payment of common stock dividends. This type of covenant restriction is disclosed in a company’s 10K filing with the SEC.

07
Dividend Reinvestment Plans or DRIPs

•••When you use direct stock purchase plans, dividend reinvestment plans, or DRIPs, you pay little or no commission. This leaves more cash in your pocket. Wall Street doesn't advertise these programs because if you use them, it loses the fee income. Tatiana Maramygina / FOAP / Getty Images

Unless you need the money for living expenses or you are an experienced investor that regularly allocates capital, the first thing you should do when you acquire a stock that pays a dividend is enroll it in a dividend reinvestment plan, or DRIP for short.

How Dividend Reinvestment Plans Work

When an investor enrolls in a dividend reinvestment plan, he will no longer receive dividends in the mail or directly deposited into his brokerage account. Instead, those dividends will be used to purchase additional shares of stock in the company that paid the dividend. There are several advantages to investing in DRIPs; they

are:

Enrolling in a DRIP is easy. The paperwork (both online and in print) can normally be filled out in under one minute.
Dividends are automatically reinvested. Once the investor has enrolled in a DRIP, the process becomes entirely automated and requires no more attention or monitoring.
Many dividend reinvestment plans are often part of a direct stock purchase plan. If the investor holds at least one of his shares directly, he can have his checking or savings account automatically debited on a regular basis to purchase additional shares of stock.
Purchases through dividend reinvestment programs are normally subject to little or no commission.
Dividend reinvestment plans allow the investor to purchase fractional shares. Over decades, this can result in significantly more wealth in the investor's hands.
An investor can enroll only a limited number of shares in the dividend reinvestment plan and continue to receive cash dividends on the remaining shares.

In fact, I like dividend reinvestment programs so much that I once wrote an essay for my friends explaining how my family had used the Coca-Cola dividend reinvestment plan to teach my youngest sister how to invest in stock. It became a learning experience so that by the time she reached high school, she understood the relationship between business, profits, dividends and investors.

08 Practical Examples of Dividend Reinvestment Plans in Action

Direct stock purchase plans and DRIPs make it easy to compound your wealth because you can setup automatic investment plans that take money from your bank account to buy shares regularly. Dividends can be reinvested at little or no cost.

Full Enrollment in a DRIP: Example

Jane Smith owns 1,000 shares of Coca-Cola. The stock currently trades at $50 per share and the annual dividend is $0.88 per share. The quarterly dividend has just been paid ($0.88 divided by 4 times a year = $0.22 per share quarterly dividend). Before she enrolled in Coca-Cola’s dividend reinvestment plan, Jane would normally receive a cash deposit of $220 in her brokerage account. This quarter, however, she logs into her brokerage account and finds she now has 1,004.40 shares of Coca-Cola. The $220 dividend that was normally paid to her was reinvested in whole and fractional shares of the company at $50 per share.

Partial Enrollment in a DRIP: Example

William Jones owns 500,000 shares of Altria group. The stock currently trades at $49.75 and pays an indicated annual dividend of $2.72 per share ($0.68 per quarter). William would like to receive some cash for living expenses but would like to enroll some of the shares in a DRIP. He calls his broker and has 300,000 shares enrolled in Altria’s DRIP.

When the quarterly dividend is paid, William will receive cash dividends of $136,000. He will also receive 4,100.50 additional shares of Altria Group giving him holdings of 304,100.50 shares (300,000 shares * $0.68 dividend = $204,000 divided by $49.75 per share price = 4,100.50 new shares of Altria Group).

Dividends on Dividends

Why are dividend reinvestment plans conducive to wealth building? Notice that William now has 4,100.50 additional shares of Altria stock. When the next quarterly dividend is paid, he will receive $0.68 for each of those shares. That additional income works out to $2,788.34. Those dividends will be partially reinvested in the stock, buying more shares which will pay more dividends.

In even the smallest portfolio, dividend reinvestment plans can result in substantial increases in value over extended periods of time. To demonstrate the power of dividend reinvestment through DRIPs, consider the example given in Jerry Edgerton and Jim Frederick’s August 1, 1997 Money magazine article, Build Your Wealth Drip by Drip: if you had put $10,000 in Standard & Poors 500 stock index at the end of 1985 and not bothered to reinvest your dividends, you would have had $29,150 by the end of 1995. Had you reinvested the dividends, however, your total would have been more than $40,000.

In other words, reinvesting those seemingly small dividends resulted in an extra $10,850 over ten years. Assuming you continued to add to your principal investment and held those stocks for thirty or forty years, the difference could be hundreds of thousands of dollars or more.

More Information - Our Ultimate Guide to Dividend Investing

You're now ready to move on to our Ultimate Guide to Dividend Investing. There, you'll learn advanced dividend strategies, how to avoid dividend traps, how to use dividend yields to tell if stocks are undervalued, and much more.

Capital Gains Tax Holding Periods

Determining Tax Rates for Your Investments

The total capital gains tax you pay is largely determined by the length of time an investment is held. Uncle Sam prefers rewarding long-term shareholders of American businesses. Although the individual tax rates are apt to change, the holding periods generally are not. It is absolutely vital that you realize the buy and sell date the government uses to determine the length of time you held the asset is the trade date (the day you ordered your broker to buy or sell the investment), not the settlement date (the day when the certificates changed hands).

Capital gains tax on assets held less than one year

Appreciated assets sold for a gain after being held for less than a year receive the least favorable capital gains tax treatment. Generally, the gain will be taxed at your personal income rate (which includes your earned income plus capital gains). In some cases, the capital gains tax can reach almost twice as high as those levied on long-term investments.

Capital gains tax on assets held more than one year but less than five years

The Internal Revenue Service considers assets held longer than one year to be long-term investments. In May of 2003, Congress lowered the capital gains tax rate to 15% for those in the higher rates and 5% for those in lower income tax brackets. Originally, there was a sunset provision for these capital gains tax rates to expire at the end of fiscal year 2008. In 2006, Congress passed a two-year extension through fiscal year 2010 to keep these favorable rates in place.

According to the IRS literature, “The highest tax rate on a net capital gain is generally 15% (or 5%, if it would otherwise be taxed at 15% or less). There are 3 exceptions:”

"The taxable part of a gain from qualified small business stock is taxed at a maximum 28% rate."
"Net capital gain from selling collectibles (such as coins or art) is taxed at a maximum 28% rate."
"The part of any net capital gain from selling Section 1250 real property that is required to be recaptured in excess of straight-line depreciation is taxed at a maximum 25% rate."

The ramifications of capital gain tax rates on your investment decisions

A woman in the 35.0% tax bracket invests $100,000 in a stock and sells it six months later for $160,000 (a 60% return). She owes $21,000 in taxes on her $60,000 capital gain, leaving her with a $39,000 profit.

The same woman invests $100,000 in a stock and sells it one year later for $150,000 (a 50% return). She owes capital gains taxes of $7,500, leaving her with a net profit of $42,500.

Despite the fact that her return was 10% lower in the second transaction, she ended up with nearly 9% more money in her pocket. The lesson: Capital gains tax implications should be a serious consideration for almost every investment.

More Information About Capital Gains Tax Holding Periods

For more information about capital gains, capital gains taxes, and capital gains tax holding periods, read The Beginner's Guide to Capital Gains Taxes.

Current Liabilities

Understanding the Components of Current Liabilities

When preparing to analyze a company, one of the first things you'll need to do is to grab a copy of the company's most recent balance sheet. Though it may look like it's written in a foreign language to many new investors, I'll help you decipher the code so that you'll be more confident in your own investment analysis. Let's begin with current liabilities. The current liabilities section of the balance sheet shows the debts a company owes that must be paid within one year.

These debts are the opposite of current assets. Current liabilities include things such as short-term loans from banks including line of credit utilization, accounts payable balances, dividends and interest payable, bond maturity proceeds payable, consumer deposits, and reserves for taxes.

Below are some of the most common and important current liabilities on the balance sheet.

Accounts Payable: The Most Popular Current Liability

Accounts payable is the opposite of accounts receivable. It arises when a company receives a product or service before it pays for it. Accounts payable, or A/P as it is often shorthanded, is one of the largest current liabilities a company will face because they are constantly ordering new products or paying wholesale vendors and suppliers for services or merchandise. Really well-managed companies attempt to keep accounts payable high enough to cover all existing inventory.

In effect, this means that the vendors are paying for the company's shelves to remain stocked. The most effective operators in industries such as discount retailers, Target and Wal-Mart among them, have turned this into an art. In a very real sense, their business growth was funded by vendors such as Procter & Gamble and Clorox, both of which shipped products to the store shelves on credit, giving the merchants a chance to sell the goods before paying the amount owed to these wholesalers.

This meant both Wal-Mart and Target could use more of the money they had raised from shareholders, bondholders, and retained profits to fund new store expansion.

Accrued Benefits and Payroll as a Current Liability

This item in the current liabilities section of the balance sheet represents money owed to employees as salaries and bonuses that the company has not yet paid.

Short-Term and Current Long-Term Debt

These current liabilities are sometimes referred to as notes payable. They are the most important item under the current liabilities section of the balance sheet and most of the time, represent the payments on a company's loans or other borrowings that are due in the next twelve months. Using borrowed funds is not necessarily a sign of financial weakness; e.g., an intelligent department store executive may work out short-term loans at Christmas so she can stock up on merchandise before the seasonal rush. If demand is high, the store would sell all of its inventory, pay back the short-term debt, and pocket the difference. This use of leverage can result in higher returns on equity.

How can you ever hope to tell if a company is wisely borrowing money (such as our illustrative department store), or recklessly going into debt?

Look at the amount of notes payable on the balance sheet (if they aren't classified under the notes payable section, combine the company's short-term obligations and long-term current debt). If the amount of cash and cash equivalents is much larger than the notes payable, you shouldn't have any reason to be concerned.

If, on the other hand, the notes payable has a higher value than the cash, short-term investments, and accounts receivable combined, you should be greatly concerned. Unless the company operates in a business wherein inventory can be turned into cash rapidly, this is a serious sign of financial weakness.

Other Current Liabilities on the Balance Sheet

Depending on the company, you will see various other current liabilities listed. Sometimes they will be lumped together under the title "other current liabilities." Normally, you can find a detailed listing of what these "other" liabilities are buried somewhere in the annual report or 10-K.

Often, you can figure out the meaning of the entry by its name. If a business lists "Commercial Paper" or "Bonds Payable" as a current liability, you can be fairly confident the amount listed is what will be paid out to the company's bondholders in the short term.

Consumer Deposits Are Liabilities to Banks

If you are looking at the balance sheet of a bank, you will want to pay close attention to an entry under the current liabilities called "Consumer Deposits." In many cases, this will be listed under other current liabilities, if not lumped with them. This is the amount that customers have deposited in the bank. If you're asking why consumer deposits are a liability, the answer is quite simple. Since, theoretically, all of the account holders could withdrawal all of their funds at the same time, the bank must list the deposits as a current liability.