Investing in companies that pay dividends to shareholders is a common way to generate steady, reliable income from your investment portfolio. However, not every stock that pays a dividend is the same, so it’s important to understand how dividends work and what differentiates dividend investments before you dive in. If you’re interested in committing a part of your portfolio to dividend investing, this article will cover everything you need to know to get started.
What is a Dividend?
A dividend is a payment issued to qualified shareholders from a company’s profits. Most often, dividends take the form of cash payments, although they can also be issued in the form of stock or company products. Ultimately, dividends are another way that companies can offer returns to shareholders beyond just increasing their share prices.
Whether or not a company issues a dividend, the timing of any dividend and the amount paid out are all controlled by the company’s board. Importantly, dividends must also be approved by voting shareholders. Dividends may be issued at any time, but most companies choose to issue them on a quarterly or annual basis. On occasion, companies will also issue one-off dividends as a way to reward shareholders after a particularly profitable quarter or year.
When thinking about how much a company’s dividend is worth, it’s important to consider dividend yield in addition to cash value. Dividend yield is simply the total dividend paid out per share over the course of a year divided by the price per share. So, dividend yield normalizes dividends according to how much you paid for a share in the first place.
Note, though, that since dividend yield depends on the stock price, it can be distorted by big gains or losses. For example, a dividend yield might look very attractive when a stock’s price plummets, even though you would lose money because of the loss in share value. So, you’ll still want to look at the dividend value in addition to yield.
Dividend Reinvestment Plans
While dividends are often paid out in cash, a large number of publicly traded companies also offer dividend reinvestment plans. With these plans, shareholders are given the option to use their dividend to purchase additional shares (including fractional shares) of the issuing company rather than receive cash.
These additional shares are sold directly from the company’s reserves and must be sold back to the company to redeem them for cash. However, shares purchased through dividend reinvestment plans are often sold at a discount to market value and with little or no commission. That makes them a very good deal for stockholders and enables your holdings of the company to compound over time.
Dividend Stocks vs. Non-dividend Stocks
Whether or not a stock pays out dividends can have important effects on the stock price and your returns over the long term.
First, it’s important to realize that dividends are priced into the share price. Often, a dividend stock’s price will go up in the days ahead of the ex-dividend date (the last day to qualify to receive the next payout) and will drop in the days after it. Non-dividend stocks don’t experience the same cyclic behavior.
Over the long term, choosing a dividend vs. non-dividend stock can also have a major impact on your total return. If the stock price were to never change, for example, you’d still receive a return from a dividend stock thanks to the quarterly or annual payouts. Dividend payouts can also help offset a loss on the stock price over time. For non-dividend stocks, you don’t have the same cushioning if the share price drops.
That said, it’s important to remember that a dividend represents a company giving away a portion of its profits. That money isn’t going towards reinvestment in growth, so the company may in turn see less of a rise in share price over time compared to a company that doesn’t issue dividends. With a non-dividend stock, what you give up in guaranteed payouts you may gain in long-term share price returns.
Here’s an example using two large companies. Verizon has consistently paid dividends for the past five years. During that time period, the stock price increased ~20%. Here is the stock chart (the “D’s” mark dividend payments):
We can compare this to a company like Adobe that has not issued any dividends. The stock price is up over 400% over the same period. Here is the chart:
It should be noted that there is not a direct correlation between a stock’s price increase and it’s dividend yield. Issuing a dividend does not mean a company cannot grow. Companies like Apple have seen explosive growth while offering modest dividends. That said, dividend companies are often thought of as “income-generating” components of a stock portfolio. Dividend investors often have different goals than growth investors.
It’salsoimportant to keep in mind that dividends do have tax consequences. For most investors, this isn’t a major concern. But, if dividends could push you into a higher tax bracket, you may want to stick to non-dividend stocks.
When choosing a dividend stock, there are a couple things to consider.
First, look closely at the dividend yield. This represents the amount that you can expect to earn each year in the absence of any change in stock price. Here are some examples of stocks sorted by the highest dividend yield (available through Dividend.com):
A higher yield is generally better, although there are a number of other things to think about before simply buying the stock with the largest available yield.
The frequency is also important, especially if you’re relying on your dividend investing portfolio to generate fixed income. In that case, you may prefer a monthly or quarterly payout to an annual dividend. If you’re holding a stock for the long-term and reinvesting your dividends, the frequency may not matter as much to you. You will also want to make sure a company has a strong history of issuing dividends. The company should be reliable and predictable.
Dividend growth and yield growth over time are things you’ll want to look closely at. Seeing the dividend grow over time is generally a good sign of long-term financial health. Continued dividend growth can also push up the stock price, which translates to additional returns. Conversely, a declining dividend can signal that a company is in trouble and can scare away investors. In that case, you’re not only getting less return in dividend payments but also facing a potential drop in share prices.
Along the same lines, make sure to look at how stable the stock price has been over the long-term. A 5% dividend yield is much less impressive if the company has a history of losing 5% of more of its share value in a single year or is trending downward.
Lastly, you will want to make sure the company you are investing in is legitimate. Companies with exceptionally high dividends may seem “too good to be true,” and they often are. Make sure to do your research to make sure you are investing a strong company with a strong track record.
Dividend Investing Tips
The most important tip that new dividend investors can take to heart is to look for companies with high dividend yields and stable stock prices. This combination ensures that you’re putting your money into a company that offers solid returns and won’t leave you losing money as a result of dramatic swings in the stock price. It helps in this regard that many of the companies offering dividends are mature blue-chip stocks with a long history of steady growth. The more trustworthy the company, the better off your dividend investments will be.
Importantly, a high dividend yield isn’t everything. There are many scams companies that offer unrealistically high dividends. In other cases, young companies offer massive dividends that aren’t sustainable – if a company gives away 80% of its earnings in dividends, there is little money left for it to continue growing. If a dividend looks too good to be true, it probably is.
Still, you don’t have to shy away from stocks and sectors that are offering good dividends because they’ve been doing well recently. For example, REITs have seen strong performance, so it’s not surprising that many companies are raising dividends or issuing one-off dividends to shareholders. There are plenty of good, lesser-known dividend stocks out there for investors who are willing to do their research.
Services to Help with Dividend Investing
Speaking of dividend stock research, there are a few services available to help. Yahoo! Finance makes it relatively simple to find dividend stocks thanks to its stock screener, which has a filter for dividend yield. For more advanced research, check out Dividend.com. This handy site keeps a running list of recommended dividend stocks, tracks stocks with exceptionally high dividend yields, and monitors ex-dividend dates for the majority of dividend-paying companies.
Alternatives to Dividend Investing
Dividend investing is a good strategy for developing a fixed income stream, but it isn’t right for every investor. Dividends are great for generating income from your investments. Many of the companies that pay dividends are also considered to be safer investments. The dividend itself doesn’t make a company safer, but dividends are often distributed by established companies with steady business (i.e. American Express, Verizon, etc.).
If you prefer to invest in up-and-coming growth companies, you’re unlikely to be investing in dividend stocks. You’re likely to invest in companies in growing sectors such as technology. If this is your investment strategy, you can do your own research, or you can rely on stock picking services like the Motley Fool to provide you with stock recommendations. These companies will do the research for you and present you with actionable buy and sell alerts for growth stocks.
While the returns may be less stable than dividend investing (higher-risk, higher reward), historically, these stocks have outperformed dividend portfolios by a significant margin.
Dividend investing is a widely used strategy that offers guaranteed income through payouts from the companies you own. This type of strategy is particularly useful for retirees looking to generate low-risk fixed income, but it can be used by any investor to maximize yields over time.
When choosing dividend stocks, it’s important to look closely not just at the dividend yield, but also at the stock’s price stability and the long-term health of the underlying company. If you’re looking to start investing in dividend stocks, there are a number of tools that you can use to research potential investments.