What Is Dividend Investing?
Investing in companies that pay steady dividends is a tried and true strategy for investors looking to maintain or even grow investing income.
With such slow, steady growth, some might even say it’s boring! But the resulting income will be sure to gain you more than enough return when you are patient and focused on applying the fundamentals of dividend investing.
Earlier generations of investors favored and relied upon dividend investing—and while those generations enjoyed higher yields than are often available today, there are still plenty of benefits to a dividend investing strategy.
Dividend investing is the strategy of buying stocks in dividend-paying companies and holding them for the long term to receive dividend payments regularly.
Dividend investors seek out companies with a history of paying dividends and strongly prefer companies that have increased their dividend payments year over year, known as dividend growers.
What Is Dividend Income?
Dividend income is the payments received by shareholders of a company that has distributed some or all of its profits to investors.
Dividends are usually paid quarterly, but some companies pay monthly or annually. Dividend income can come from dividend-paying stocks, mutual funds, exchange-traded funds (ETFs), and real estate investment trusts.
The income from dividends can be reinvested back into the dividend-paying security to purchase more shares, or it can be taken in cash. This cash can be left to build up in your investment account, or you can take a dividend distribution and use it to fund your daily living expenses.
Why Do Companies Pay Dividends?
Dividends are a way for companies to share profits with their shareholders; most companies that pay dividends generate more cash flow than they can use, so they distribute any extra cash to shareholders over and above what is required to fund operations.
Dividend payments are made out of a company’s earnings, and the amount of dividend paid is decided by the board of directors.
Advantages and Disadvantages Of Dividend Investing
Just remember, there are advantages and disadvantages to understand before you set out to invest in pursuit of dividend income.
First and foremost: Dividends are never guaranteed, and companies can and do change them at will.
In addition, they’re more commonly paid out by larger, more mature companies that are growing more slowly.
Unlike large corporations, small corporations are more likely to reinvest their earnings back into the company. This could possibly lead to a higher rate of stock growth.
Personally, I have a mix of steady, large companies that pay me dividend income, as well as small, up-and-coming companies that don’t yet pay dividends but have the potential for high rates of return.
I believe this gives me the best of both worlds: current dividend income to fund my lifestyle or reinvest, as well as capital appreciation potential from the small companies in my portfolio.
How to Evaluate Dividend Stocks
To evaluate dividend-paying stocks, look at the dividend yield. A dividend yield is simply the percentage of a company’s annual profits that are distributed to shareholders. Companies with a higher dividend yield tend to distribute a more significant proportion of their profits to shareholders.
A company’s payout ratio is another factor to consider when evaluating dividend-paying stocks. Payout ratios measure the amount of profit left after paying out dividends. Companies with lower payout ratios generally have less debt and therefore have more room to grow their dividend. As a result, they are able to invest more in research and development and expand their operations.
Companies with low payout ratios typically reinvest most of their profits back into their businesses. These companies are more focused on growing their businesses rather than distributing profits to shareholders. Investors should focus on companies with higher payout ratios since they are more likely to continue investing in their businesses and provide better returns.
To evaluate dividend stocks, you need to analyze the financials of the business; some of the critical areas to focus on include:
1. Earnings Prospects – How does the stock perform financially? Is it profitable? Does the company generate consistent profits? Are its earnings increasing or decreasing?
2. Return On Equity – What is the return on equity? A ratio of net profit divided by total shareholder equity. Higher numbers indicate greater profitability.
3. Cash Flow – How much free cash flow does the company generate? Free cash flow is defined as the difference between operating revenue and capital expenditures. Companies with positive free cash flows tend to grow faster than those with negative free cash flows.
4. Dividends Paid – How many times per year do shareholders receive dividends? Higher dividend amounts mean better value.
5. Market Cap/Book Value Ratio – How large is the market cap compared to book value? Book value is calculated by multiplying assets by the book value per share. A larger number indicates a stronger balance sheet.
6. Price/Earnings Ratio – How expensive is the stock relative to its earnings? Lower price/earnings ratios indicate better values.
7. Dividend Yield – How much yield does the stock pay? Higher yields could indicate higher income but potentially more risk of a dividend cut depending on the underlying company.
8. Beta – How volatile is the stock? A beta rating below 1 means less volatility.
9. PEG Ratio – How cheap is the stock compared to its earnings? A cheaper stock is usually a safer investment because it tends to move up or down less than pricier stocks.
10. ROIC – How effective is management? A higher return on invested capital indicates better performance.
11. Sales Growth – How fast are sales increasing? Higher sales growth rates indicate better performance.
12. EPS Growth – How fast are earnings increasing? Higher earnings growth rates indicate better performance.
Tax Benefits of Dividend Investing
There are several reasons why dividend investing can be beneficial for your personal finances. First, dividends are generally considered to be free money. You receive them without paying any additional fees or taxes. Second, dividends are usually reinvested within the corporation, meaning that you’ll earn interest on your original investment. Third, dividends may reduce your taxable income. Finally, dividends can provide valuable tax benefits for income investors.
Most dividends paid by American companies are qualified dividends, meaning that if you hold them for 60 consecutive business days, the dividend income is taxed at lower rates than ordinary income. These types of dividends are typically taxed at the lower long-term capital gains rates. However, there are exceptions. Some dividends are unqualified dividends, which are taxed at higher regular income rates.
Money market funds and other cash equivalents pay ordinary dividends, which are taxed like regular income. Because of this, dividends from these investments are not eligible for favorable long-term capital gains treatment.
You should consider whether you qualify for the favorable long-term capital gains treatment when deciding whether to invest in dividend stocks. If you do qualify, you can potentially save thousands of dollars in taxes annually.
How Dividend Reinvestment Boosts Your Returns
Investors should consider dividend reinvestment whenever possible. Even though stocks tend to rise in value over time, most investors don’t receive any additional benefits from holding onto their stocks. Instead, they simply sell off their holdings at market prices and pocket the proceeds. By reinvesting dividends instead of selling, you can enjoy greater returns over time. As the dividend increases, you obtain more shares and continue to reinvest the dividends, which creates a “dividend snowball.”
You can play with the numbers yourself using a free dividend reinvestment calculator, which, once you enter some variables, will show you the effects of dividend reinvestment on your overall returns.
The Risks to Dividends – Are Dividends Safe?
During the stock market crash of 2008, many of the major banks had to cut or eliminate dividend payouts to conserve funds to continue operations and hold assets for potential losses from loans. Banks historically were known to be one of the safest dividend payers with consistent dividend payments quarter by quarter.
Dividends are not guaranteed and can be impacted by risks at the macroeconomic or company level. This could impact your income and is something you have to be aware of when building your portfolio.
As we stated earlier, by having some lower payout ratio dividend stocks within your portfolio, these companies can often withstand a bumpy patch in the macro environment and still continue paying a dividend, whereas a company that has a very high payout ratio may not be able to continue paying the full dividend.
You can help reduce the overall risk by having a diversified portfolio that has a number of dividend-paying stocks, some high payout ratios, high yields, and others with lower payout ratios and lower (but growing) yields.
In addition, you can mix in some bonds, real estate investments, and Treasury Bills to provide income that is not based on dividend payments.
How To Get Started Dividend Investing?
If you’re interested in dividend investing, the best place to start is by opening a brokerage account. You can open an account for as little as $500, and there are many brokerages that offer dividend reinvestment plans (DRIPs) with no commission fees.
Once you have your account open, you can begin buying stocks.
But if you are entirely new to investing, I would recommend doing what is called “paper trading.” Paper trading is where you pretend to buy stocks with fake money and track what would have happened if you actually did make the trade.
This is a great way to get started and learn about dividend investing without actually putting any money at risk. You can find out how much money you need to start dividend investing here.
There are even some web applications that allow you to paper trade and will adjust the values of the fictional money and track things like dividend payments etc.
Once you have practiced investing with paper trading and know how things work, you can start by investing some real money into a brokerage account.
Wrapping Up
Dividend investing is a great way to increase your returns over time. By reinvesting your dividends, you can obtain more shares and continue to receive dividend payments, which creates a “dividend snowball.” By learning the basics of dividend investing and working to build your knowledge and experience over time, you can reap the rewards of an ever-growing stream of dividend income.