Dividend investing can be a powerful investment strategy. It involves buying quality stocks from companies that pay good dividends while taking advantage of capital appreciation over time. Thus, dividend stocks allow you to create a steady flow of income while increasing your portfolio value. Or, you can decide to reinvest your dividend earnings into more dividend stocks to take advantage of compounding and exponential growth.
However, over the last decade or so, investing in dividend stocks has fallen out of favor. Many investors these days tend to focus on finding the next “get rich quick” stock. In other words, the next Amazon, Google, or Apple. Of course, growth stocks can bring huge returns, but they also carry high risks. A balanced portfolio should include a mix of asset types and investment vehicles to reduce risk and volatility. Adding some dividend stocks will minimize risk and might be the way to create that basket of assets that will bring you the long-term returns you have always dreamed of.
Publicly traded companies that earn profits have to decide what to do with those earnings. They can either reinvest all their earnings back into the company for various reasons, such as expanding their business or paying down their outstanding debt, or distribute part of their profits to their stockholders in the form of dividends. Typically, these distributions are regular cash payments, either monthly, quarterly or annually.
Please note that not all public companies pay dividends. For example, although most of the S&P 500 companies pay dividends, some growth companies such as Facebook, Google, Tesla, and Amazon, have decided not to pay dividends and retain all their earnings for quick growth potential.
Investing in dividend stocks is an excellent strategy for investors looking for relatively safe investments, a steady income stream, and wealth accumulation over time.
However, not all dividend stocks are created equal, and it is challenging to find high-quality dividend stocks that will help you achieve your desired goals. This article discusses everything you should know before investing in dividend stocks and how to find those quality stocks that will ensure the regular income stream and capital appreciation you are expecting.
What are Dividend Stocks?
Dividend stocks are stocks from established public companies that share part of their profits with their investors in the form of regular dividend distributions. Dividend stocks benefit the investor in two ways. First, investors will receive regular dividend payouts. Second, investors will get capital appreciation of the stock over time. Dividend investing is an excellent strategy for investors looking for low-risk, long-term investments that will enable them to live the life of their dreams during retirement.
Buying dividend stocks can be very lucrative over time if you make intelligent choices. Many companies offer dividends, but please note that not all dividend stocks are good investments. Furthermore, dividends are never guaranteed!
For example, stocks of companies that offer dividend reinvestment plans should be on your list of stocks to consider. These companies allow you to reinvest your dividend distributions into more dividend stocks rather than taking them as a cash profit. This strategy works well when your dividends are small, or you do not need the additional income.
Instead of taking the cash payment, you can reinvest these dividends, buy more shares, and then use the dividends from these new shares to buy even more shares. This way, you can take advantage of compound dividends.
Reinvesting dividends will make your investments grow faster than you imagined in the long run. Just check out the graph below. Typically, compounding dividends make up a tiny part of your total investment early on, but they grow significantly in size as time goes by. As a result, compound dividends will have contributed the bulk of the total return on your investment in the long run.
Source: Morningstar and Hartford Funds 2/21
As you can see from the graph, if you would have invested $10,000 in the S&P 500 index in 1960 and you would not have reinvested the dividends, your investment in 2020 (60 years later) would be worth $627,161. Now, compare that to what your investment would be worth if you had reinvested your dividends. Your $10,000 investment would be worth a whopping $3,845,730! This means that almost 84% of the S&P 500 index’s total return can be attributed to the power of compounding reinvested dividends.
Another way to add dividend stocks to your portfolio is through investing in certain funds. For example, many brokerage firms offer dividend-paying index funds, mutual funds, and Exchange Traded Funds (ETFs). These funds often give you the option to reinvest the dividends at no extra charge. This strategy lets you increase your investments at no cost, making it easier to stay on track and meet your investment goals.
Dividend Basics and Metrics
Investors holding shares of any dividend stock have to meet specific requirements before being eligible to receive a dividend payout. For example, you must be a “shareholder of record” on or after the date decided by the company’s board of directors to qualify for a dividend.
It is also essential to know the ex-dividend date for a stock. If you buy on or after this date, you will not be included in the next round of dividends and will not receive the latest payout. Instead, the seller will receive that round of distributions. The ex-dividend date for stocks is generally one business day before the record date. Companies announce the ex-dividend date to make the dividend process transparent by clarifying when you should hold the stock to get a share of the company’s profits.
Before buying dividend stocks, investors should evaluate the quality of each stock they purchase. Here are some key metrics that can help you assess the certainty of a regular dividend payout, how much you can expect in dividend income, and how to identify dividend red flags and dividend stocks in trouble.
Dividend Payout Ratio – This is the ratio of the total amount of dividends paid to shareholders relative to the company’s earnings or net income. In other words, this ratio measures the percentage of net income that will be distributed as dividends to shareholders. The dividend payout ratio is a significant financial metric that indicates the sustainability of a company’s dividend payment program.
For example, assume that Company X reported a net income of $4 million for the year. In the same period, Company X issued $1.5 million of dividends to its shareholders. The DPR calculation is as follows:
So, the 37.5% dividend payout ratio shows that Company X pays its shareholders 37.5% of its net income in dividends and keeps 62.5% as retained earnings to grow the business.
There is no ideal or perfect payout ratio because that number depends on the sector in which the company operates. Typically, cyclical industries, such as luxury goods, have less sustainable dividend payouts because their profits fluctuate dependent on the state of the economy. In contrast, companies in defensive industries, such as utilities, have a higher payout ratio as their earnings and cash flows are more stable.
Generally, a 30 to 50% dividend payout ratio is deemed reasonable, and dividend payments are considered sustainable, while anything over 50% could be unsustainable.
Please do not discount a dividend stock right away when you see a very high payout ratio. This ratio is just one of the factors to consider. Suppose other factors indicate it might be a quality dividend stock. In that case, you should dig deeper and do some more research, especially if the company shows a consistent dividend growth rate over the long run.
Dividend Yield – This is a stock’s annual dividend payments per share divided by the dividend stock’s current price, multiplied by 100. The dividend yield is expressed as a percentage. A stock’s dividend yield shows you the rate of return in the form of cash dividends to shareholders. In other words, the ratio shows the percentage of dividends received for every dollar of stock owned. Please note that while high yields might look desirable, those yields may be at the expense of the company’s potential growth. Therefore, it is not smart to evaluate a dividend stock solely based on its dividend yield.
Here is an example of how to calculate dividend yield. Assume that company X’s current share price is $50. For one year, the company paid consistent quarterly dividends of $0.40 per share. The dividend yield ratio for Company X is calculated as follows:
As you can see, the annual dividend yield for the investor is 3.2% a year. As average dividend yields differ significantly between industries, it is best to only compare dividend yield ratios for companies in the same industry.
Dividend Growth Rate – This ratio tells you how often and how much the company raises a stock’s dividend from year to year. The dividend growth rate is expressed as a percentage, and it is typically calculated on an annual basis. For example, to calculate the growth rate between 2 years, you take the annual dividend from the second year and divide it by the annual dividend of the first year. Then you subtract 1. A company’s dividend growth rate helps determine its long-term profitability and whether its dividends are sustainable.
For example, let us assume that Company X shares part of its profits with its shareholders in the form of dividends. In year 1, the company distributed $1.60 in dividends, and in year 2, it was $1.70. To determine the dividend’s growth rate from year one to year two, we will use the following formula:
Cash Dividend Payout Ratio – This ratio shows the remaining portion of cash flow (after capital expenditures and preferred dividends payments are deducted) that a company uses to make its common stock dividend payments. It is a highly significant metric because the earnings and cash flow can vary from time to time because of expenses. The cash dividend payout ratio can be used in conjunction with the payout ratio to evaluate how sustainable the dividend is.
Total Shareholder Return – TSR is an accurate measure of financial performance, primarily when evaluated over a more extended period. You can calculate it by adding up the dividend stock’s capital gains (current price – purchase price) and the dividends earned and dividing this sum by the purchase price.
P/E Ratio – The price-to-earnings ratio is useful for valuing a company’s stock to indicate if it is overvalued or undervalued. You can calculate the P/E ratio by dividing a stock’s market price by the company’s earnings per share.
EPS – To calculate the earnings per share ratio, you divide a company’s profit by the outstanding shares of its common stock. Quality dividend stocks grow their earnings per share consistently over time and thus increase their dividends regularly.
Characteristics of Quality Dividend Stocks
Finding quality dividend stocks that are worthy of your investment dollars is not an easy task. It is a time-consuming process that requires in-depth research and fundamental analysis. Here are some factors you should consider when looking for quality dividend stocks.
Stock safety/dividend sustainability – A good dividend stock increases its yield over time. If a company pays out most of its profits as dividends, it might not have enough money left over to run its operations and invest in future growth.
This potential lack of funds might make its dividend distribution plan not sustainable in the long run. Stocks will be “safer” dividend stocks when the company only shares a reasonable part of its profits with its shareholders and reinvests the rest back into the company for future growth. For most companies, a dividend payout ratio of 30 to 50% is an ideal ratio. This ratio indicates a high likelihood that the company will have enough funds available for sustaining its dividend payments in the long term.
Stock valuation – The valuation of a stock is essential when looking for quality dividend-paying stocks. A stock might appear attractive because it offers a high dividend yield. However, this high dividend yield might have been an intentional move by management to keep its investors happy because the stock price fell. This price drop could mean that the dividend is in danger of being cut, or the business is in trouble and might not survive in the long term. Therefore, It is essential to be on the lookout for these types of dividend traps.
Furthermore, valuation is an important metric. It makes sense to compare dividend stocks against their competitors and the market, so you can buy them at a fair price and not at a premium.
Economic moat and pricing power– The profitability of a company is essential to successful dividend investing. A company with a sustainable competitive advantage (economic moat) and pricing power will likely be profitable long-term. The wider the moat, the safer the dividend, and the higher the chance the dividend yield will increase each year.
Furthermore, businesses that can raise their prices without losing market share or unit volume will still be profitable even during high inflation.
Debt-to-Equity ratio – A large amount of debt can jeopardize a company’s regular dividend payments during economic downtimes. Therefore, it is wise to look for financially relatively conservative companies with a Debt-to-Equity ratio that is one or lower, which means that the company has at least $1 of equity for every $1 in debt.
It does not mean that companies with higher Debt-to-Equity ratios that might look good otherwise should be eliminated for consideration. However, these companies do require some further research into their debt situation.
Apart from the D/E ratio, there are some other metrics, such as a company’s revenue growth, Return on Capital (ROC), and Return on Equity (ROE), that can be helpful when looking for the best dividend stocks.
State of the company and industry – It is also essential to evaluate the company itself and its industry. Is the company’s business at risk from competitors, weak demand, or some other disruption? Is the industry growing, and what is the industry outlook and growth potential? After these types of questions have been answered, you will have the information necessary to decide if a dividend stock is worth investing in.
Dividend aristocrats are public companies that have a record of increasing their dividends for a minimum of 25 consecutive years. These dividend stocks are considered some of Wall Street’s safest investments because of their track records of consistent performance and steady and predictable returns to their shareholders. This consistency and predictability are why long-term investors are often eager to invest in these companies.
Several institutions have developed dividend aristocrats listings, and the most popular one is S&P 500 Index. The index updates its list of dividend aristocrats every year based on the information obtained from the previous year. To be eligible to stay on the listing, companies must:
- Increase their dividends at least once per year
- Have a float-adjusted market cap of at least $3 billion
- Have an average daily trading value of at least $5 million
New companies are added as they hit the 25-year requirement. The list of 2021 shows that there are 65 companies listed as dividend aristocrats on the S&P 500 index.
Though dividend stocks are often considered “boring,” studies show that dividends with their compounding power represented over 75% of total S&P 500 market returns between 1980 and 2019.
Warren Buffett, CEO of Berkshire Hathaway, is probably the most famous and biggest value investor globally. He has always focused on fundamentally good businesses, and this strategy has served him well. Part of his success has been due to his investments in the following five dividend aristocrats: Procter & Gamble, Johnson & Johnson, Coca-Cola, Chevron, and Abbvie.
Despite the pandemic, these five aristocrats have each had more than 2% dividend yields, with Abbvie and Chevron having around 4% and 5%, respectively.
Dividend Investment Strategies
Dependent on the underlying goal, dividend investors either focus on high dividend growth or dividend yield strategies. These two goals are opposites. Investors who want immediate income will follow a high dividend yield strategy, while investors who are in it for the long haul will follow a high dividend growth strategy instead. Others are looking for a more moderate strategy that will combine both.
Here are some of the most effective strategies for those who want to generate income with dividend investing.
High dividend yield strategy – This is a popular short-term dividend investment strategy ideal for generating some quick cash. It aims to invest in established slow-growing companies that have high current dividend yields. The main goal is to find stocks that pay high dividends but are priced low because they are out of favor. They are typically stocks in defensive sectors such as food, housing, and utilities.
The main disadvantage of this strategy is that dividends are never guaranteed. Especially in slow-growing companies, dividends can be reduced or cut anytime if something unexpected happens and cash is in short supply.
Dividend growth strategy – This is a popular passive strategy amongst investors who want to generate a steady income stream to fund their retirement. This type of investment won’t give much in dividends in the short term as the dividend yield is pretty low. However, as the company grows and raises its stock’s dividend yield regularly, dividends will be substantial, and when reinvested, the portfolio will exponentially increase in value. As a result, the steady stream of income at retirement will be significant. Therefore, a dividend growth strategy makes a great long-term investment strategy.
This is an excellent strategy for an investor who starts with a small investment and, with the help of compounding dividends, can turn it into a steady stream of income and a decent size nest egg during retirement.
The dividend growth strategy is far more advisable and less risky than buying high-yield stocks that may turn out to be dividend traps.
Dividend capture strategy – This strategy is a more active approach to dividend investing. The dividend capture strategy does not require holding dividend stocks for a quarter or a year. Instead, it allows you to buy them just before the ex-dividend date and sell them immediately after the dividends have been distributed. This strategy involves some risk but can be a great way to generate short-term gains.
Investors should determine what level of risk they are willing to take and how long they can wait for the dividends to produce good returns before deciding what dividend investing strategy is best for them.
Reasons to Add Dividend Stocks to Your Portfolio
Steady income stream – The most significant advantage of investing in dividend stocks is that it is one of the most effective ways to generate a steady passive income. This is especially appealing to individuals planning for retirement and who want to keep their stock’s initial investment value while also receiving a stable, reliable income stream to replace part of their employment income.
Compounding dividends – Another reason to add dividend stocks to your portfolio is that dividends are a great way to build wealth through compounding. If you do not need the cash income, you can reinvest the dividends to buy more stocks which entitles you to more dividend payments in the future. This will have a compounding effect on your investment returns and is one of the best ways to build wealth through capital appreciation in the long term.
Defense in a bear market – Last but not least, dividend investing is an excellent defense in a declining economy or a bear market. Even if your portfolio is down, you most likely will still get dividend income because most high-quality dividend stocks are less affected by economic downturns. After all, they are from large-cap mature companies with large cash flows that can usually withstand these downturns.
Avoid the Following Dividend Investing Mistakes
There are some common mistakes you should be aware of and try to avoid when pursuing dividend investing.
A false sense of security – Many investors perceive all companies that pay dividends as safe investments. However, this is not always the case, and it is a mistake to assume that all dividend stocks are safe. First and foremost, dividends are never guaranteed. Companies can decide at any time to reduce their distributions or to eliminate them. For example, during the Covid-19 pandemic, several established companies with a long history of solid dividend growth either reduced or suspended their dividends. Some of the companies that did this are Wells Fargo, Carnival, Ford, and Boeing.
Second, although companies that pay dividends are typically more defensive and conservative than growth companies that do not pay dividends, some dividend-paying companies are risky. For example, sometimes, a company might increase its dividend yield not because its earnings have increased but to appease investors who are unhappy because of the declining stock price. However, it is deceiving and not good practice because the company should focus on future growth and stability instead.
To prevent this false sense of security from creeping in, you should not only consider dividend payments in your investment decisions but other aspects of dividend stocks such as a company’s fundamentals as well.
Going after high dividend yield – The most common mistake with dividend investing is to look for stocks with the highest dividend yield. Often investors are tempted to keep switching to stocks with a higher yield. This is not always a good idea because there will always be stocks that offer a higher yield. A higher yield does not mean a better quality stock. High dividend yield stocks can indicate a company in trouble. The yield might be high because the company’s share price has dropped because of financial problems, which can eventually reduce future dividends or cut them altogether.
Therefore, a better long-term strategy would be to invest in high-quality, stable stocks with sustainable dividends rather than going after stocks with the highest yields.
As a reference, the average yield of a dividend-paying S&P 500 company has historically been between 2% and 5%. Therefore, a stock dividend yield that is significantly higher is a red flag and should be carefully scrutinized before you add it to your portfolio.
Overlooking tax implications – Please note that all dividends are taxable and must be reported to the IRS. Ignoring tax implications is another dividend investing mistake you should avoid. Make sure you always check what tax you will have to pay on your dividend distributions because different dividends have different tax implications. For example, qualified dividends are subject to capital gains tax instead of ordinary income tax. This is an advantage as capital gains tax levels are often lower than your income tax levels. Ordinary dividends are taxed at the federal income level rate.
Ignoring diversification – Dividend investing does not replace the importance of portfolio diversification. Although it might seem like a great idea to only invest in dividend-paying stocks because they provide stability, are a relatively safe bet, and offer a regular income stream, this is not the case. Including other assets in your portfolio reduces volatility when dividend stocks don’t perform as expected. Furthermore, stocks that pay dividends typically do not usually outperform high-quality growth stocks. So adding some of the non-dividend paying high-growth stocks to your portfolio might give you that extra growth you need to reach your goals.
Trying to time the market – Trying to time the market is very challenging, and making any prediction about short-term price movements can be risky. In addition, when selling dividend stocks in the short term, you might miss out on dividend distributions and be subject to income tax instead of capital gains tax. Therefore, it is best to buy a dividend stock at a fair price and then hold on to it for the long term.
One of the most significant benefits of investing in dividend stocks is the tax advantages investors might get when using dividends to generate income. There are two categories of dividends; qualified dividends and ordinary dividends. Qualified dividends are taxed at the often lower capital gains rate, and ordinary or nonqualified dividends are taxed at the often higher federal income tax rate. In addition, qualified dividends have to meet special IRS requirements:
- The dividends must have been paid by a U.S. corporation or by a qualifying foreign entity
- The underlying security must have been owned for a minimum holding period. This holding period is at least 60 days for common stocks and 90 days for preferred stocks.
- They should not be on the IRS’ “do not qualify” list.
The maximum capital gains tax rate is 20%, while the top federal income tax rate is 37%. So, the type of tax paid on dividends can have a significant impact on your overall returns.
Generally, most dividends paid by U.S. and qualifying foreign companies are classified as “qualified,'” which means they are taxed at the lower long-term capital gains rate. Other dividends are classified as ordinary dividends and are subject to federal income tax. In addition, dividends of certain asset classes are earmarked explicitly as nonqualified and may even be subject to a separate surtax. Common examples of such assets are Real Estate Investment Trusts (REITs), Master Limited Partnerships (MLPs), and special one-time dividends.
Luckily, this extra tax burden does not apply to dividend stocks in tax-advantaged retirement plans such as IRAs.
Quality dividend stocks can be a great addition to most investors’ portfolios. They can provide you with a steady stream of income at retirement, the advantage of compounding dividends when they are reinvested, and they can protect your portfolio in a declining market.
Of course, every investing strategy involves risk, and dividend investing is no exception. The most significant risks are that dividends are never guaranteed and that not all dividend stocks are created equal. Therefore, it is crucial to do some in-depth research and put some time and effort into finding quality dividend stocks.
Furthermore, when creating a portfolio, you should never forget to focus on diversification because lack of diversification exposes you to increased volatility. Although you can find dividend stocks and funds in many industry sectors, some sectors and classes of companies are not well represented. For example, many successful fast-growing tech companies do not pay dividends, nor do many small and medium cap companies.
Therefore, when building a balanced, diversified portfolio, you should look at the big picture. Quality dividend stocks certainly earn a place in a diversified portfolio. However, so might growth stocks, bonds, and other asset classes. So, dependent on your risk tolerance, time horizon, and financial plan, dividend stocks might be an excellent addition to your portfolio.