Understanding the difference between alpha and beta gives you a new way to understand the true source of investing results, be it the specific selections you have made or the broader market.

Big ideas

In investing, alpha and beta are **complementary performance indicators** that relate an asset’s growth and volatility to a suitable benchmark.

Beta, alpha and beta coefficients are **mathematically defined** and based on publicly available information; they can’t be fudged, fabricated, or misconstrued.

However, when it comes to interpreting alpha and beta, market conditions must still be taken into account. These numbers provide a useful **snapshot of an investment** – but only a partial one, based solely on past performance.

**"The stock market is filled with individuals who know the price of everything, but the value of nothing." **

“You don’t know what you can’t measure” is kind of a truism in investing. Hard data is almost universally preferred to gut feelings, astrology, and what some guy told you at the pub!

Not everything is quantifiable, of course: the skill of a company’s management team or the “attractiveness” of a new product line can, at best, be estimated. When measurable information is available, though, it pays to have a **framework you can use to analyze figures** in a consistent, rational way.

This is why professional investment managers are always talking about alpha vs beta. Finance is inherently complex: **reducing a large data set to a few simple numbers** greatly facilitates communication. Indicators like alpha and beta make it easier to get a grip on a stock without spending hours on research. 

Once you understand the dynamic of alpha vs beta, investing becomes less of a Gordian knot … though these two numbers certainly aren’t the only factors you should be tracking. Nothing substitutes for fundamental analysis and keeping an eye on the news.

What are alpha stocks?

Investors are often told to minimise risk while maximising rewards. This is good advice, much like "eat your vegetables". It’s of limited use, however, without any way to put these concepts into numbers. Beta, alpha, and a few other Greek letters can give investors the equivalent of “five-a-day” rules of thumb they can put into practice.

Alpha’s definition in finance **relates to the “rewards”** part of the equation. In simple terms, it places a numeric value on a stock’s tendency to outperform the market as a whole. It’s the “edge” a particular investment or portfolio has over the average of comparable assets. In other words, a higher-alpha investment yield returns that aren’t the result of the market as a whole increasing in value.

Example of alpha

The red section traces the performance of our chosen benchmark (perhaps the FTSE 100) as a ‘baseline’ performance an investor might expect. The yellow shows a portfolio that includes high-alpha stock prices, which rise faster (by 25 basis points) than average. The pink section represents an even higher alpha set of investments that rise even faster (by 50 basis points). When an investor retires, the difference in alpha can make a substantial difference to expected spending power.

Formula for alpha

Calculating a share’s or fund’s alpha is child’s play:

**α =Ri - Rm**

Where **Ri** is the investment’s return, and **Rm** is that of the market (or other index) during the same period.


If, for example, a certain stock has grown by **15%** in a year while the market as a whole managed **10%**, that means its **alpha is 0.05 or 5%**. Another stock that returned only 7% will have an alpha of -0.03 or -3%.

**Note: There also exists a related concept called **Jensen’s alpha**, which explicitly takes a stock’s volatility into account. The two terms (alpha and Jensen’s alpha) are often used interchangeably. People also tend to state alphas of either type as percentages without using the “%” sign, which sometimes causes confusion.**

**α(Jensen)=Ri - Rf+β(Rm-Rf)**

Where **Ri** is the investment’s return, **Rm** is that of the market, and **β** is the beta coefficient defined below. 

**Rf** is a theoretical value known as the “risk-free rate of return”; in practice, it can be obtained by subtracting the inflation rate from the returns of government bonds.

One point to always remember is that alpha coefficients only make sense when comparing investments with **similar risk profiles**. If, for example, you used the FTSE 100 as a benchmark for a portfolio heavy on tech stocks, you may fool yourself into thinking it has achieved a fantastic alpha number. This would be misleading, though, as technology investments are riskier and more volatile than the FTSE 100. The first step in knowing how to find the alpha would be to choose a more appropriate index, such as the FTSE techMARK.

So, what are alpha stocks exactly?

All shares, and indeed other types of securities, have their own alphas. You may also see the terms “alpha companies” or “alpha investment strategy” thrown around. These terms refer to attempts or opportunities to beat the market’s rate of return by putting money into carefully selected high-alpha investments.
Of course, this is easier said than done. In practice, it also means exposing your capital to so-called **idiosyncratic or specific risk**, which connotes the possibility of a particular security losing value regardless of what’s happening in the financial market as a whole. Alpha investment strategies, therefore, normally include measures to hedge against idiosyncratic (company-specific) risk.

Shouldn’t we all just be chasing stocks with higher alphas, then?

Whether in politics, investing, or even plumbing, looking for simple solutions to complex problems isn’t always the right approach (and may be fruitless anyway). It’s certainly tempting to think that, once armed with the alpha definition, finance suddenly becomes easy. But this is only somewhat true.

Pros of high alpha

✔️ Calculating (or, more commonly, looking up) a stock’s alpha is easy and straightforward. You’ll be able to quickly weed out unsuitable investment options if high returns are what you’re after.

✔️ In a growing market, many smaller companies tend to outperform the market. The stocks with high alpha coefficients will usually generate higher returns but also carry greater risk.

Cons of high alpha

❌ Because this metric is so widely used, identifying high-alpha companies brings only temporary success. Assuming that a stock’s winning streak continues, other investors who know the formula for alpha will buy up more shares, meaning that the stock’s competitive edge will soon be “priced into” its market value.

❌ What are the alpha stocks of yesterday going to do tomorrow? Outperforming the market in the past, especially over a short period, is no guarantee that an investment won’t experience an equally sharp decline in the future. If the market as a whole goes into a slump, defensive stocks with traditionally low alphas may offer better returns.

In short, selecting investments is never just a matter of weighing alpha versus beta. Diversity in your portfolio, along with other tried-and-true investment lessons, should still be at the forefront of any investor’s mind.

What are beta stocks?

Whereas alpha focuses on returns (specifically, how much alpha stocks exceed those of similar investments), **beta is all about risk**. Yet beta is not simply the opposite of alpha. These terms have very different but complementary meanings. If you know both a stock's alpha and beta, you already have a pretty good idea of what to expect from it even if you don't know anything else about the company.

Like alpha, beta is a historical measurement based on an investment’s past performance. It, too, uses an index or other benchmark as a basis for comparison. The difference between alpha and beta is that gains are all that matter for alpha,  whereas beta only tracks **fluctuations in value** without regard for eventual returns.

Example of beta

All stocks (and other kinds of assets) change value at different rates. Taking the blue line as the benchmark, stable shares like the green line don’t move as much – they have low betas. Others, like the red line, are more volatile than the market as a whole, and their beta coefficients are high. As the chart demonstrates, it makes sense to own high-beta stocks at the beginning of a new bull market and own low-beta stocks at the start of a new bear market.

In the hypothetical graph above, all shares rise and fall in tandem with the market as a whole. The key to understanding beta (versus alpha especially) is that this needn’t be the case. An asset with a high beta does not necessarily change its value in lockstep with the benchmark. Over time, the two will usually follow the same trends, but any stock may fall while the index to which it’s most closely related rises, or vice versa.

Formula for beta

It’s rarely necessary to calculate betas and alphas yourself; many investment websites and tools have beta listings available for all publicly traded stocks. If you’re mathematically inclined, the following formula for beta may be of interest; if not, just look at it once and then forget it forever.

**Beta (β) = Covariance / Variance**

where:

Covariance measures how a stock's return moves relative to the market's return.

Variance measures how the market moves relative to its mean.

The beta (β) of an asset is calculated by dividing the covariance of the asset's return with the benchmark's return by the variance of the benchmark's return over a specific period.

Understanding beta (vs alpha)

First, investment beta is a bit more complicated than investment alpha, which is a pretty intuitive concept. If, for instance, a  stock has α = 0.02 and the market gains 10%, that stock’s value can be expected to rise by 12%. Here are a few factors that illustrate why the beta is more complicated:

The** beta of the index** used, by definition, **is always 1**. 

**A portfolio invested largely in blue-chip stocks will have a beta of close to 1**. (Since indices such as the FTSE 100 are weighted averages, large-cap companies have a proportionate effect on their values).

As shown in the formula for beta, **cash has a beta coefficient of zero**. Whatever happens to the stock market, the value of cash (in pounds and pence, ignoring inflation) stays the same.

**Small-cap and tech stocks** are more sensitive to changes in market conditions and **usually have betas larger than one**. With a high beta, stock prices are more mobile. If a stock has β = 2 and the market rises (or falls) by 10%, those shares should gain (or lose) about 20%.

**Larger, established companies** tend to be more stable, as do sectors like manufacturing. These stocks usually **have betas lower than one** and stable share prices.

Betas are sometimes calculated for non-share investments, such as precious metals and bonds, using an index based on the stock market. This is meant to be illustrative rather than analytical, though. Beta and alpha don’t allow you to directly compare apples with oranges.

So, what are beta stocks exactly?

Since beta is a measure of volatility,  it’s often used as an **estimator for risk**. In investing, beta and alpha are not exact synonyms for “risk” and “returns”, though they’re sometimes used as a kind of shorthand for these concepts. Beta is more about volatility: with a high beta, stock prices can go dramatically up as well as down. The potential upside is obviously not equivalent to the possibility of taking a loss, though the formula for beta treats these in exactly the same way as long as they’re in line with market trends.

A more accurate way of describing beta relates to **exposure – specifically to systematic or market risk**. An investment strategy based on beta (vs alpha) can help a broker structure a portfolio in such a way that a client’s exposure to ordinary market fluctuations is quantified. Any given tolerance for risk can be reliably accommodated.

Outperforming the market is not the priority when you’re focusing on beta coefficients. Alpha stock prices can offer greater gains, but also carry idiosyncratic risks that a beta strategy seeks to limit. Beta funds tend to be more **passively managed**, tracking an index rather than actively hunting for promising companies.

Practical investing: alpha vs beta shortcomings

An asset's alpha and beta are important metrics. They should be seen for what they are, though: understanding them doesn't quite turn you into a skilled quantitative analyst. 

Many mathematical tools are available to investors. The key to using them effectively is to realise that, like all statistical summary measures, alpha vs beta in investing doesn’t tell the whole story. It’s important to resist the temptation of inspecting a few trees in detail while ignoring the forest.

**“Investors should be sceptical of history-based models. Constructed by a nerdy-sounding priesthood using esoteric terms such as beta, gamma, sigma and the like, these models tend to look impressive. Too often, though, investors forget to examine the assumptions behind the models. Beware of geeks bearing formulas.”**

A stock’s alpha and beta clarify the past but don’t predict the future

Share prices tend to reflect changes in underlying business conditions before these show up in a stock's alpha and beta. For these metrics to be meaningful, the basic business environment needs to remain roughly constant. Both need to be taken with a grain of salt if, for instance, a company that relies heavily on imports or exports is affected by Brexit or a technology the company needs to adapt to changes in its competitors' strategies.

Credit Suisse’s share price and beta up to its recent collapse. The beta coefficient was indeed high for a bank, but that alone didn’t predict catastrophe. 

*Past performance doesn’t guarantee future results.*

Alpha and beta both become more trustworthy indicators as more time passes. As we just mentioned, though, this implies that both the company in question and its market don’t undergo any major changes during the time period its alpha and beta are measured. Taking on more debt, acquiring another company, or changing the business’s focus will all render its alpha and beta coefficients virtually meaningless.

Alpha and beta ignore business fundamentals

Value investors – those who focus on a company’s inherent worth rather than its share price ( especially if the latter is lower than the former) – usually don’t pay much attention to alpha vs beta. Finance and stock prices, to them, are a kind of abstraction of what a business actually does and are not intrinsic indicators of its value. 

As these investors might point out, a stock that's recently suffered a steep decline will have negative alpha and high beta, making it a bad investment in that sense. However, the company may equally well be due for a rebound – again, alpha and beta do not tell the whole story.

Both metrics are tied to the market (or another index) 

Choosing an inappropriate benchmark can lead to meaningless numbers. Whatever index is selected as a baseline when calculating alpha, for instance, should be commensurate in risk to the investment. Mutual funds and their managers like to keep score of their relative performances in terms of alpha, but this only makes sense if their portfolios carry similar levels of risk. (Beta, though a good first approximation, isn’t a perfect estimator of downside exposure.) 

Beta measurements are often used as part of a diversification strategy. This is all well and good as far as it goes – the whole point of using beta in investing is to minimize the unsystematic risk associated with individual investments. Getting caught up in the numbers, however, can also disguise excessive exposure to a particular sector if the wrong benchmark is used. 

Calculating either alpha or beta for a diversified portfolio, including stocks, bonds, gold, real estate, and perhaps other alternative investments, gets pretty tricky. This, too, is because of the difficulty of selecting an appropriate index for each class of investment.

Recap

A little bit of knowledge can be a dangerous thing. We all tend to prefer simple explanations for complex phenomena.

Easily measurable facts like percentage returns of a stock or earnings growth can mask the wider context. When you look at stocks’ performances in terms of alpha and beta, markets do make a little more sense. Both of these metrics are just tools, though. Like a screwdriver or hammer, each does one specific thing and should not be applied to jobs for which they’re not suited.

FAQs

Alpha vs Beta in Investing Performance. What are alpha stocks? Definitions, Examples, Pros and Cons of Alfa and Beta stocks in Investing. Practical investing.

Alpha vs Beta Stocks in Investing: Definition, Examples, Pros and Cons

Alpha vs Beta in investing performance: definition, examples, pros and cons

Alpha vs Beta in investing performance

Dollar cost averaging is a proven way to take advantage of long-term investment opportunities while removing tough decisions about timing buy and sell orders.

Focusing your efforts on investing consistently over time yields better results than trying to time your investments perfectly.

**"If you like spending six to eight hours per week working on investments, do it. If you don’t, then dollar cost average into index funds."**

Big Ideas

Dollar cost averaging is a way to spread your stock purchases over time, reducing the risk of bad timing.

Dollar cost averaging works well as part of a long-term investment strategy.

With the benefit of hindsight, dollar cost-averaging in S&P 500 funds during the ‘great recession’ of 2008 was a shrewd investment strategy.

What does dollar cost averaging mean?

Dollar cost averaging (DCA), or as it is sometimes called, the constant dollar plan, means consistently investing a certain amount of money in a particular security over time. The investing pattern should be followed regardless of what’s happening in markets.

This strategy helps reduce your average buying price during a down market and gives you a cushion against market volatility. You will be spending small amounts of money over time; that means you’ll be buying stocks when the prices are low and also when the prices are high. That ultimately averages out the price of stocks over time.

Another benefit of dollar cost averaging is that you don't have to invest so much of your time and effort keeping tabs on the markets. Since you will follow a regular investing pattern, you should be oblivious to the continuous market ups and downs.

Investment and retirement accounts like [ISAs in the UK](https://www.trading212.com/learn/investing-101/what-is-an-isa-and-how-does-it-work) or IRAs and 401(k) in the USA are popular vehicles to enact dollar cost-averaging plans.

What is dollar cost averaging in practice?

Dollar cost averaging

For instance, if you earn £2,000 monthly and allocate £200 of the salary to your pension plan. Out of the £200, you could opt to invest £100 in an [S&P 500 index](/learn/investing-101/s-p-500-index) fund and £100 in another mutual fund.

Every month, £200 will be deducted from your salary and invested in the two funds, no matter the price. You will invest during the market highs and lows over the year; hence, the term ‘dollar cost averaging,’ i.e. the prices you paid average out over time.

Dollar cost averaging vs lump sum investments

A big question many investors face when they have built up a ‘war chest’ of funds to invest is whether to opt for dollar cost averaging or make a lump sum investment. To think this through, consider these three aspects:

Your ability to stay consistent and stick to your investing plan

How long can you hold on to the investment (investment horizon)

Lump-sum investing is about investing the entire investment or all your investable funds at once. Usually, people invest a lump sum if they receive a windfall from inheritance or the sale of another asset or when they judge that the market is about to hit a low.

To clarify, the lump sum needn’t be invested into just one stock or one asset. You can add to pension funds or diversify your stock portfolio by investing in different stocks or index funds. This will act to minimise risks from relying on only one investment.

Both lump sum investments and dollar cost averaging are effective for investing money, so the choice between them is your own.

If you have a low-risk tolerance, dollar cost averaging is probably the right strategy for you. It will help spread your investment amount over time. However, if you are more tolerant of risk, perhaps because you are just beginning your career, lump sum investing offers the chance of higher returns within the same period, but with higher risk.

The **benefits of lump sum investing** are as follows:


A study conducted by Williams and Bacon showed lump sum investing yields higher returns than dollar cost averaging about two-thirds of the time.

Investing the whole amount rather than keeping cash in hand offers greater market exposure, including exposure to greater gains and losses.

**Lump sum investing has a few drawbacks** as well:

Market fluctuations can be unpredictable, so the investment carries high risk.

If you are not risk averse, you may get emotionally invested in watching your investment, possibly leading to poor decisions.

Lump sum investing is not a consistent strategy for the long run.

**Verdict: Dollar Cost Averaging Vs. Lump Sum**

Lump sum investment can yield higher returns, so if your main objective is to enhance the performance of your investment, go for it.

If you are not very risk-tolerant, dollar cost averaging might be more suitable because you slowly increase the risk over time, putting less at stake at the beginning.

LSI vs DCA: Investing just before the financial crisis

As you gain experience and can better handle risk, you can invest more at specific times rather than spreading the investments throughout the year. 

The most important thing is to devise a plan of action. Set realistic goals and be mindful of the risk exposure you are willing to take on your investment.

Dollar cost averaging benefits

A dollar cost averaging strategy is easy to start and understand and can be followed by novices as well as pros. Here are a few main benefits of the strategy.

✔️ Not timing the market

With dollar cost averaging, you don't have to invest efforts to time the market. Since the markets are often unpredictable, DCA keeps you safe from mistiming the market and making the wrong calculations or investment decisions.

✔️ Fewer emotions

Your emotions and psychological biases stay out of your investing decisions in dollar cost averaging. Often people fear losses due to market lows and make the wrong decisions. DCA, while being consistent, keeps you free from such worries.

✔️ Long-term gains

The market usually follows an upward trend over time. So if you keep investing, you will see that even market crashes can be great opportunities over the long term. Your investment won’t result in a loss but would only yield higher over the years.

✔️ It's automatic

It's an automatic mode of investment. You don't have to wait for the market to fall or think about when to invest.

✔️ Healthy investment practice

DCA is about investing regularly, slowly building wealth over time while minimising risk.

**Pros of dollar cost averaging:**

➕ DCA minimises risk by spreading the investment over time in portions.
➕ You don't have to time risks and the market.
➕ Following DCA makes you avoid impulsive and rash investing decisions.

**Cons of dollar cost averaging:**

➖ Not investing during opportunistic times can translate to limiting your gains.
➖ You must stick to the DCA plan, which requires resisting the urge to time the market and getting tempted to invest during the market lows.

Dollar cost averaging frequency

Different investors follow different frequencies for their dollar cost average strategy. It can be as often as a daily practice for some; others may opt for weekly, monthly, semi-annual, or annual investments.

1. Daily dollar cost averaging

Since you will invest every day, every spike in the price, either up or down, could be captured. This means many dips can be bought, but on the other hand, you would also be buying on the rallies.

Moreover, the strategy also keeps you updated and in the know about developments in market prices.

Looking further out, your investments made over time (during the highs and lows) would eventually average out like any DCA plan.

2. Weekly dollar cost averaging

Depending on your ability to invest or how and when you get your salary, you can opt for the weekly plan.

When considering a weekly DCA vs monthly DCA, one consideration is the cost of transferring money. Fortunately, with Trading 212, bank transfers are normally free, but [funding your account by credit card](https://www.trading212.com/terms/invest) can incur fees.

3. Monthly dollar cost averaging

Most investors prefer the monthly dollar cost averaging method. This is a more familiar frequency to those used to a SIPP plan where funds are taken directly from your salary and invested into your investment account. A monthly DCA plan suits those who prefer a more laissez-faire approach - you can just invest once every month without keeping tabs on the market or volatility.

If you get your salary once a month, you can tie the investment amount with the salary and let it be deducted automatically from your bank account.

The main drawback is that you may miss some market opportunities during the daily slumps, which average out by the time your monthly deposit is made.

So there are different dollar cost-averaging frequencies. You can decide which works best for you over the long term.

Dollar cost averaging formula

There is no particular need to remember a dollar cost averaging formula because the idea is easy to grasp.

However, using the following method is useful to keep track of your average buying price - something that is much easier to record if making less frequent investments.

**Average Buying Price = Amount Invested / Number of Shares Owned**

Dollar cost averaging S&P 500 ETFs

The S&P 500 index is one of the simplest and most diverse places to employ a dollar cost averaging strategy. You can pick your favourite S&P 500 index fund or ETF to invest in at the same time every month.

Investing at the index level rather than picking stocks means not only are you removing the decision over timing but also largely removing the decision over which stocks to include in your portfolio.

Chart: 100-year history of the Dow Jones

*Past performance doesn’t guarantee future results.*

Even for those who like to pick stocks, simultaneously dollar cost averaging into index ETFs like the S&P 500, FTSE 100 or DAX 40 adds some diversity to the way you go about achieving your long-term financial goals.

Keep dollar cost averaging in a bear market

Investing during bear markets is tricky. Even if you have opted for the dollar cost-averaging method, investing during dips can be stressful. Naturally, in a market that historically rose over time, the best time to do dollar cost averaging is in a bear market when prices are lower to lower your averaging buying price.

In short, bear market DCA allows you to buy more low-priced shares before the market climbs again.

Be careful, though. Novice investors often assume that when the market goes up, all the individual stocks that fell will go up just as much. But many of the stocks that dropped in a bear market never recover and get replaced by other successful companies.

One way to overcome this is, instead of focusing on individual stocks, to concentrate on the broad market index. More importantly, even when dollar cost averaging is important, it is important to review the companies you own periodically and make sure it still makes sense to own them.

Dollar cost averaging is one of the most trusted investing strategies because it is easy to follow, doesn't involve timing the market, and is a proven way to achieve long-term gains. Buying on a regular basis spreads out the risk of stock market investing but tends to underperform strategies with large exposure to the market, such as lump sum investing.

What is Dollar Cost Averaging? Dollar cost averaging vs lump sum investment. Learn about different frequencies: weekly vs monthly. Dollar cost averaging S&P 500 ETFs.

What is Dollar Cost Averaging: Dollar Cost Averaging Formula

What is dollar cost averaging?

Investing in stocks to earn a return through dividends can be an excellent way to generate passive income and build wealth - and it requires relatively little upkeep.

Characteristics of a good dividend stock

You need to get familiar with the important characteristics that make a good dividend-paying stock. This is the kind of stock that you’d want to keep in your portfolio year after year. Specifically, these characteristics fit into two camps:

**Qualitative** - Looking at the business itself and what it does

**Quantitative** - Analysing the numbers

The qualitative features of a company are what it does, the industry it is in, how long it has existed etc. We give the example of Warren Buffett’s favourite [Coca-Cola](https://www.trading212.com/trading-instruments/isa/KO.US).

Quantitative measures such as the price-to-earnings ratio are formulas used to judge the size and health of a dividend.

Qualitative characteristics

The tactic of the stock brokers led by Leonardo Di Caprio in the Wolf of Wall Street was to first offer their clients a blue-chip stock to gain their trust before flipping them into pink sheets and penny stocks that earn very high commissions.

The first qualitative characteristic you should look for is that the company should not be the kind of “exciting opportunity” that stockbrokers would call you about! The company must be stable. If investors make money in exciting companies, it will be through the growth in the share price - not through dividends.

With a good dividend stock portfolio, you shouldn’t need to be constantly following the market with sophisticated techniques. You are a long-term passive shareholder directly benefiting from the profitability of a company. Dividend investors are generally looking to avoid risk and excessive stock price fluctuations so that they can comfortably grow their portfolio incrementally over time.

Understanding a company's stability and the industries, it operates in doesn’t have to take forever. A combination of research and common sense is needed. You need to get to know the company and what it does and decide whether it is a business that has good long-term prospects.

Watch our video

Warren Buffett’s stock with a good dividend

Warren Buffett has held shares of Coca-Cola since the late 1980s; the company accounts for about 8.5% of Berkshire Hathaway's portfolio at the time of writing.

79,000 employees - this is a huge company. 

It’s in the consumer / non-cyclical sector - which is generally seen as defensive in a portfolio.

It’s in the beverage industry - which is a stable industry to be in, although not all beverage companies are stable.

Owns major brands, Coca-Cola obviously, Sprite, Fanta but also Costa coffee, Vitamin Water, Minute Maid etc. 

To further your knowledge of a company, you can join the quarterly conference call that management holds after releasing quarterly earnings. Here you can hear the management discuss the company and hear analysts asking about what they think is currently important for the business.

It really doesn’t need to take more than a few hours to investigate a potentially good dividend stock to buy, which you might end up being invested in for years - even decades!

Quantitative characteristics

Here are 5 quantitative techniques to help decide what is a good dividend stock.


**1. Dividend yield**

This is probably the most basic technique for filtering your stock choices. The dividend yield is how much return in dividends you will get from your investment in a particular stock.

Dividend yield = (Dividend per share / Stock price) x 100

If the share price is $100, and it pays a dividend of $5 a year then the dividend yield is 5%.


When dividend investing, one of the things to be avoided is what is called a "dividend trap" stock. These stocks pay a high dividend and look like great investments if you’re only looking at the dividend yield. That high dividend acts like blinkers over people's eyes - they see the big returns and miss some big underlying issues with the company.

As a general rule, It's not advisable to apply a single criterion. Try to include various techniques and give yourself the best chance at filtering out the bad stocks.


**2. Dividend growth rate**

Stable companies are to be cherished but one thing that should not be stable is the dividend payout. The best scenario is when companies raise it gradually over time. That way the investor earns more and has a better chance of keeping pace with inflation.

A company's history of past dividend payments is publicly available information and can easily be found online.

Payout history of Coca-Cola

Past payouts are not a prediction of the future but a good dividend stock history does demonstrate that the company is capable of doing what you need it to do.


**3. Payout ratio**

Since investing is all about holding for the long term, you want to make sure the stock you choose can keep up its payments. One of the ways to do that is to check the payout ratio, which is what percentage of the company's profits are paid out in dividends.

Dividend payout ratio = Dividends paid / Net Income

A payout ratio in the 40-50% range means more than half of the company's profit is reinvested into growing the company.

Generally speaking, a lower payout ratio is more sustainable. It can also mean a lower dividend yield. This is a balance that you must strike when selecting your stocks.


**4. Debt-to-profit**

Another potential threat to the company’s stability is if it has a lot of debt. A company with too much debt may be forced to pay off debt instead of paying dividends.

Debt-to-profit = Total Debt / Annual Net Profit

The debt-to-profit ratio is often called "gearing". It can be seen in corporate reports expressed as debt-to-EBITDA. Generally, the lower the "gearing", the less risk the company carries. 

Sometimes raising money through debt makes sense if, for example, it means taking advantage of low interest rates or increasing production capacity. Having debt isn't necessarily a bad thing; what matters is being able to pay off the debt, and the debt is being used to grow.


**5. Price-earnings (P/E) ratio**

If there’s one ratio people tend to know about, it's the P/E ratio, and for a good reason. This is the ratio between the price of the stock and its earnings.

PE ratio = Share price / Earnings per share (EPS)

High P/E ratios (over 20) typically mean a stock is overvalued, while low P/E ratios (closer to 10) mean a stock is probably undervalued. 

Growth stocks tend to have high P/E ratios because they are not earning high profits. This is because the money earned is being reinvested to foster growth. Dividend investors are not looking for high-growth opportunities but rather companies with stable earnings.

When you’re planning to hold onto a stock for a long time, there’s no need to go bargain hunting, but you don’t want to buy a stock with a high valuation. By definition, the slower growth of a stable company does not justify a high P/E ratio, meaning the share price has a higher chance of falling below where you bought it.

There are a number of factors that can make a stock a good dividend stock. From a qualitative standpoint, the stock is typically a well-established company with a strong track record of profitability and a history of paying out regularly to shareholders. The company should also have a solid financial position, with a healthy balance sheet and consistent cash flow.

From a quantitative standpoint, a stock should have a high dividend yield (DY) and a low payout ratio. The DY is a measure of the annual payout as a percentage of the stock's current price, and the payout ratio is a measure of the company's dividend as a percentage of its earnings.

Good Dividend Stock - What makes a good dividend stock? Learn about main characteristics of a good dividend stock like: Yield, Growth Rate, Payout Ratio, P/E ratio.

Good Dividend Stock Characteristics: Dividend Growth, Payout Ratio

What makes a good dividend stock?

Reinvesting the dividends from your assets is an excellent way to build long-term wealth, provided you know how it works, understand the tax implications, and crunch the figures in advance. 

There are many types of dividend payments, but most commonly, the term refers to payments to shareholders in the form of either stock or cash.

It is at the company's discretion whether to issue dividends or reinvest profits. 

Reinvesting dividends from established companies has long been regarded as one of the most potent ways to build and maintain wealth, even during economic uncertainty.

When a company makes a profit, accumulating **retained earnings** means that they can either be reinvested in the company or distributed to shareholders. Dividends are approved by the board of directors of a given company and can be paid in a variety of ways. 

Dividends are paid equally to all shareholders of the same class, holding either common or preferred stock. Dividends are first declared and are then paid on a specific date, known as the **payment date**. 

To understand how profitable a given company is and how much of those profits they are entitled to as a shareholder, potential investors will want to take a look at both the company’s **earnings per share (EPS)** and **dividends per share (DPS)**. EPS denotes how profitable a company is for each share of stock, but this figure can be diluted by stock splits and other events such as the exercising of employee stock options. 

**DPS** is a measure of the value of the dividends a company pays out per share of stock. While all companies have an EPS, only dividend-paying companies have a DPS for analysis.  

Dividends are most frequently paid out quarterly. In rare instances, they can even be paid out monthly. 

An introduction to dividend payments

The following steps describe what you can expect for how dividends are paid out when you’re a shareholder:

The company generates profits as well as retained earnings.

The board of directors decides to make dividend payouts instead of reinvesting back into the company. 

The dividend is formally approved by the board of directors. 

The company announces the details of the planned dividend (the value per share, payment date, type of dividend, etc.).

On the payment date, shareholders are paid the dividend. 

You can easily check the dividends per share for a given company in a particular period by looking at its financial statements, such as the statement of earnings. This will clearly indicate the **dividends declared per common share.** 

The Trading 212 app makes it very simple to see all the dividend information you need for any particular investment. The following image shows an example of a dividend payment from [Apple (AAPL)](https://www.trading212.com/trading-instruments/invest/AAPL.US). The payment per share at the specific period indicated in the screenshot is $0.24, so in this example, owning 0.554 shares (a fractional share) would result in a payment of $0.133.

Note that there are two types of dividends for UK companies. Interim dividends and final dividends.

**Interim dividends** are dividends paid to shareholders during the company's financial year before the final determination of its full-year profits. They are typically paid out of the company's accumulated earnings or distributable reserves. Interim dividends are usually declared and distributed at regular intervals, such as quarterly or semi-annually, depending on the company's dividend policy.

**Final dividends**, as the name suggests, are dividends declared and paid by a company at the end of its financial year. They represent the company's final distribution of profits for the financial year. The final dividend amount is determined based on the company's audited financial statements, which reflect its actual earnings and financial performance for the entire financial year.

A look at dividend-paying companies

**‘Dividend Aristocrats’** is the term used to describe S&P 500 companies that have increased their dividends for over 25 years; some have been doing so for much longer. This table lists the Dividend Aristocrats along with the number of consecutive years they have increased their dividend payments as of 2022.

Many others of the world’s most powerful enterprises, including [IBM](https://www.trading212.com/trading-instruments/invest/IBM.US), [Netflix](https://www.trading212.com/trading-instruments/invest/NFLX.US), [Microsoft](https://www.trading212.com/trading-instruments/invest/MSFT.US), [Exxon](https://www.trading212.com/trading-instruments/invest/XOM.US), and [Apple](https://www.trading212.com/trading-instruments/invest/AAPL.US), also have a powerful history of dividend payouts. 

Investing in dividend-paying stocks is known to be one of the best ways to survive and even thrive during a recession. Those companies with a history of dividend payouts tend to be the ones that survive economic hardships and even emerge with excellent profits and larger market share after them. 

How dividends are calculated

The primary determinant for the calculation of dividends is a company's available profits. You can find the information about this in its [financial statements](/learn/investing-101/how-to-read-financial-statements), specifically the profit and loss statement or income statement. 

Trading 212 offers direct access to company financial statements. When you tap on [any instrument](https://www.trading212.com/en/Trading-Instruments/invest), scroll to ‘Financials’ to see the income statement, or go right to the bottom and tap ‘Instrument Details’ to access the annual report. 

The company's board of directors assesses the financial health, profitability, and capital requirements before deciding on the dividend amount to be distributed. The directors consider factors such as current and projected earnings, cash flow, retained earnings, and any legal or regulatory restrictions.

To calculate the dividend per share, the total amount of dividends to be distributed is divided by the number of outstanding shares held by shareholders. 

NOTE: Special dividends are one-time dividend payments made by a company to its shareholders.

**Dividend Per Share = (Total Dividends in a Period - Special Dividends) ÷ (Shares Outstanding)**

For example, if a company declares a dividend of £10,000 and has 100,000 outstanding shares (assuming no special dividends) the dividend per share would be £0.10.

Note that different classes of shares might have varying entitlements or preferential treatment in terms of dividends. Some shares may have fixed dividend rates or be entitled to higher dividend amounts before other classes of shares receive their portions.

It's also worth noting that companies may have specific policies or formulas to determine the dividend amount. They might consider factors like dividend cover, which measures the ratio of profits available for distribution compared to the dividend paid, or use a target payout ratio.

Shareholders should review the company's financial statements, dividend policy, and any relevant announcements to understand the dividend calculation methodology employed by the company.

What are the different forms of dividend payments?

Most commonly, dividends are paid in stock or cash, but there are a lot of ways through which companies can provide incentives for shareholders, depending on the circumstances.

1. Cash dividends

These are profits a company distributes to its shareholders in the **form of cash payments**. When a company declares a cash dividend, eligible shareholders receive a cash amount **for each share they own**. These payments are typically made directly to shareholders' bank accounts through electronic transfers or by issuing checks. 

Cash dividends allow shareholders to receive a **direct return on their investments** and provide them with **a source of regular income** from the company's profits.

2. Stock dividends

Also known as bonus shares, are a form of dividend payment where a company distributes **additional shares **to its shareholders **instead of cash**. Shareholders receive additional shares proportionate to their current holdings, **increasing the number of shares **they own without altering their proportional ownership in the company. 

Stock dividends are usually issued when a company wants to reward shareholders with additional equity while conserving its cash reserves. They allow shareholders to benefit from the company's retained earnings by increasing their ownership stake in the company.

3. Liqduidating dividends

A liquidating dividend, also known as a liquidation dividend, is a distribution of assets made by a company to its shareholders when it is **in the process of liquidating or winding up** its operations. It is typically paid **when a company decides to cease its business activities**, sell off its assets, and distribute the proceeds to its shareholders.

4. Special dividends

These are **one-time dividend payments** made by a company to its shareholders. These dividends are often declared when the organisation has excess cash/profits beyond its regular distributions in a given period. 

Special dividends are **typically larger than regular dividends** and are often declared as a result of exceptional events such as asset sales, windfalls, or extraordinary profits. Unlike regular dividends, special dividends are **not part of the company's regular dividend policy** and are not expected to be recurring in nature.

5. Property dividends

This term refers to the **distribution of assets** or property by a company to its shareholders instead of cash or additional shares. In a property dividend, the company transfers physical assets or investments it holds to its shareholders. This could include shares of other companies, real estate, or any other valuable assets. 

Property dividends provide shareholders with **an alternative to receiving cash or stock dividends** and allow them to directly benefit from the company's assets or investments.

6. Scrip Dividends

These allow shareholders to receive **additional shares** of the company's stock **instead of cash dividends**. Essentially, the company issues new shares to shareholders in proportion to their existing holdings.

A company announces a scrip dividend option, giving shareholders the choice to receive additional shares or cash. If shareholders choose the scrip dividend, new shares are issued to them based on a predetermined ratio, aiming to maintain equivalent value. This issuance of new shares can dilute existing shareholders' ownership. Tax implications may arise, so consulting tax professionals is advisable.


7. Preferred Dividends

These refer to the fixed, **regular payments** made to holders of **preferred shares or preferred stock**. Preferred dividends are **prioritised over common dividends** and are typically set at a predetermined rate or amount. Preferred shareholders receive these dividends before common shareholders, providing them with a higher level of income stability. These dividends are often paid out on a regular basis, such as quarterly, like regular dividends.

Dividend Payment - What are the different forms of dividend payments? Advantages and disadvantages of paying dividends. Share repurchases or Stock buybacks.

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