Dividend stock is to regular stock what a passive income stream is to a regular paycheck, at least to a degree. But, statements like these come with a number of caveats and that’s what we’re here to explore today.
To help you invest in dividend stocks successfully, we will share the most common issues investors face while selecting stocks and the metrics that help guide decision-making. We’ll also discuss the risks, so that you can enter the market knowing the potential consequences of making an investment. Hopefully, by the end of this guide, you’ll have learned the ins and outs of collecting returns on dividend stocks.
But to start things off, join us as we cover dividend basics.
What is a dividend?
A dividend is the distribution of company profits to shareholders. It’s one of the most typical ways to attract investors to a certain stock, as dividend stock gives individual shareholders the right to periodically receive passive income based on the amount of stock they hold. Of course, this is only true as long as company policy allows the sharing of profits (we will delve into this in a minute).
Retail investors find dividend stocks very appealing because a shareholder doesn’t need to do anything, relatively speaking, past the act of buying the stock, in order to receive dividend payments. It’s the gift that keeps on giving, and it’s attractive to investors who are close to retirement and looking for reliable income. Other investors also find dividend stock equally attractive, regardless of the fact that this reliability is not to be taken for granted.
Despite limited media exposure and an insignificant amount of attention from the general public, dividend stocks contribute to up to 40% of the total returns from stock. These figures are in constant fluctuation, so you can easily find papers that attribute as little as 30% or as much as 70% of total returns of investment to dividends, in historical terms. It largely depends on the time frames and the data sets that are taken into consideration, but no one would argue against the important role they play in the market.
Dividend stock cheat sheet
Investors find dividend stocks appealing for a number of reasons. Below, you can find a list of the most relevant benefits for making the investment.
Advantages of dividend stocks
- Dividends offer a regular, passive income stream that is attractive to retirees, but also to any other investor who is looking for a way to diversify their portfolio;
- Dividends are a “set it and forget it” type of investment and no trading is required to collect returns;
- Gains from dividend stocks that are reinvested into stock are taxed favorably as a long term capital gain and not as regular income;
- They provide protection from volatility in the market – investors holding dividend stock in a utility company (or other defensive stocks) fare better during bear markets because returns are collected regardless of downturns in every other aspect of the market;
- Reinvesting dividends and the resulting compound interest can significantly improve returns over a long period of time (in theory);
- Dividends can increase discipline in a company’s management team – having too much extra cash can sometimes tempt executives into unnecessary spending on acquisitions, while the obligation to pay dividends encourages cost-effective decision making;
- It helps companies project stability, attract new investors, and maintain or even increase the price of their regular stocks’
- Dividends are a public commitment and a matter of prestige for companies with a long track record of paying them to shareholders, so executives will do their utmost not to break the regular dividend payment cycle. Failing to do so will not only be a source of embarrassment but can also damage the price of regular stocks
Stocks come in many colors
Before we proceed, we need to identify the distinctive features of dividend stocks. The sheer volume of trading on the stock exchange can be overwhelming and there are many different types of stocks out there. Market analysts classify stocks by company size (small-, mid-, or large-cap), by geographic location (domestic, international), by industry (or sector, for example, health or energy), by expected returns (growth vs value), and other stock characteristics that make stocks stand out.
Each stock is not a dividend stock, and even dividend stocks themselves are referred to by different labels. Income stocks and yield stocks are two alternative labels. Also, the term defensive stocks, meaning a stock that provides consistent dividends regardless of performance (for example, utility companies or large corporations), is used synonymously with dividend stocks.
Growth stocks vs value stocks vs dividend stocks
Sometimes, investors specifically look for stock that doesn’t pay dividends. This is what is known as “growth shares” and these shareholders expect excess profit to be reinvested back in the market because they are focused on long-term returns from the increased value of the stock rather than chasing after a passive income stream.
On the other hand, value stocks are those that sell at a price that is lower than their intrinsic value. There can be many reasons these stocks are undervalued; however, investors get them at what they consider to be a bargain and expect to cash in returns once their value increases.
Since there are two ways to collect returns on investment in stocks – dividends and resale once the stocks go up in value – the common way to view them is either as growth, value, or income stocks. Some stocks can bring both returns in the form of dividends and be sold, so do proper research to make sure you are getting the right kind of stocks.
Do companies have to share profit with shareholders?
There is no obligation for companies to share their profit, so the short answer is no. At the end of the day, each company on the market, within this financial system, strives to make a profit. Since achieving profit takes coordinated effort and a lot of hard work, companies may decide that these extra funds will better serve some other goal (and quite rightfully so).
In specific terms, gains can be used to:
- reinvest in expanding operations;
- buy back stock from the market;
- repay debts;
- pay dividends to shareholders.
Of course, big companies with large profits can choose more than one of the items from the list. It all comes down to company policy.
Without getting too technical about economic theories and management styles, dividend policies outline the strategy of a company regarding the number of dividends and the interval of the payments. There are three main types of policies:
1) stable dividend policy – payments are done each year regardless of fluctuation in income;
2) constant dividend policy – a percentage of earnings is shared each year; and
3) residual dividend policy – unappropriated profit goes to shareholders once a year.
Also, keep in mind that the dividend policy of a company can be changed at any time. This is possibly the greatest risk for dividend stocks. So, is this really a passive income you can count on? Well, it can be if you do your homework, so stick around as we examine this aspect in greater detail.
How to buy dividend stock
In essence, there are three ways to buy dividend stocks: through a brokerage account, by a direct stock plan, or through a dividend stock fund. Each approach has its merits, so investors usually go for the one which is more in line with their investment goals.
As with putting money in any other asset class, it’s necessary to open a brokerage account to be able to invest in stocks. The traditional “brick-and-mortar” brokerages offer a broker and financial adviser whose job is to help you achieve your financial goals. Some investors find standard brokerage services time-consuming and costly. Don’t forget, these professionals have to be compensated for their expert advice, and this comes in the form of fees (flat rate or percentage based), commissions, or other costs.
Online brokerage accounts have grown in popularity in the past decade. Most of them don’t impose minimum account balances, but instead, they offer fixed commissions and fees, and a whole host of research tools. Online platforms are also easy to use and eliminate the need for speaking to anyone.
Direct stock plan
Investors have an option to purchase dividend stocks directly from the company that sells them. This is known as a direct stock purchase plan (DSPP) and may result in lower transaction fees and discounted loyalty offers. The use of a DSPP program is accessible to investors with small capital. However, these programs may come with restrictions for trading stocks. Additionally, they limit your choice of dividend stocks by design, so you will need a handful of unique DSPPs if you want to diversify your portfolio.
Dividend stock funds
Buying dividend stocks is available to investors in mutual funds and there are mutual funds that specifically target one type of dividends (for example, blue-chip stocks). Dividend stock funds can offer everything you would expect from a mutual fund – they can be attached to an index, or be an ETF. Since investors buy shares in a fund, this option allows access to dividend stocks tailored according to individual purchasing power. Dividend funds also provide great opportunities for diversification, but they also incur costs and returns are not taxed as long-term capital gains.
How to know which company’s dividend stocks are worth your while
This is potentially the biggest question for individual investors: how do you choose good dividend stocks? Well, for one, if you have doubts that you will be able to set aside the time required to research the market, there are fund managers and brokers that could provide guidance.
However, if you rather wouldn’t make a dent in your returns unless it’s absolutely necessary, then you are on your own. This has a steep learning curve, but if you tackle company metrics head-on, you will quickly begin to recognize indicators that will enable you to navigate through piles of data. We are mostly talking about reports on company performance, a company’s debt profile, historical track record, and such.
While this kind of research (and the insight that comes with it) will eventually improve your decision-making, bear in mind that a swift change of dividend policy can jeopardize your returns.
Track record of success
Although the measure is quite arbitrary, a long history of success and consecutive dividend payments are considered a benchmark. The longer the record, the better. Some investors recommend buying stocks from companies that have shown success for 10 consecutive years since their first initial public offering (IPO).
Current performance metrics can tell you a lot about the financial condition of a given company. While it’s easy to get lost in all sorts of reports and financial statements (of varying relevance), a metric such as return on equity (ROE) will serve to distill a lot of data into one figure. ROE is easily calculated: simply divide net income by average shareholder equity. This will show you the ratio of the shareholder’s return on investment that can be expected.
Many investors will agree that holding some debt on the books is not indicative of failure, but there are divided opinions about the level of debt that is acceptable. Big companies are accustomed to large-scale operations and can have a lot of debt without that being an issue in terms of making profits. If the amount of debt tips the scales in the wrong direction, it can absorb profits to service outstanding debts and this works against your pursuit of dividends.
Look for the debt-to-equity ratio (D/E, or total liabilities divided by shareholders’ equity) as a measure, and keep in mind that this figure will be different across industries. Generally speaking, a D/E around 1.0 is good, while negative ratios mean no dividends.
Dependence on other economic sectors
This one is easy to miss. These days, each facet of economic activity is interrelated with the general success of the economy. Energy prices are a textbook example of this and if you choose stocks in an industry that is heavily reliant on natural gas or oil, financial statements will follow fluctuations in energy (and their price). The same goes for the availability of raw materials and food supply or similar essential commodities.
Given the abundance of choices, each investor tends to streamline the process of selecting good dividend stock. Hence, investors welcome the idea of reducing analytical data to a figure or a ratio because such values can instantly provide a clearer picture of the quality of the stocks. The debt-to-equity ratio is one of them (we discussed it above), but other ratios like dividend payout ratio, dividend yield, and dividend coverage ratio are also considered relevant.
Let’s take a minute to describe how they are calculated.
Dividend payout ratio
The formula goes like this: annual dividends (per share) divided by earnings (per share) and the result is multiplied by 100 to get a percentage. Alternatively, the dividend payout ratio (DPR) can be calculated by dividing total dividends by net income.
This dividend metric shows the portion of a company’s gains that goes into dividend payments. It’s recommended to go for dividends with mid-range DPR (40% to 60%) because these companies are considered stable. High DPR might be tempting for investors, but beware, since the records show that it’s very hard to sustain a high DPR ratio over a long period.
This is a ratio between the annual dividends (per share) and the price of stocks (per share). Dividends are paid by number of shares, so yield is also affected by the volume, even though this can’t be calculated in a standardized formula. Rather, it changes with the number of stocks you hold.
Companies share this metric publicly, but individual investors can calculate it on their own as well. Dividend yield is particularly important for investors who are looking for a source of income – obviously, everyone wants higher returns for the same amount of investment. High yield (+10%) is an indicator of cooked books (and bigger risk), while low yield (~2,5%) is considered a sub-par return in the short term.
Dividend coverage ratio
Dividend coverage (DCR) is calculated by dividing annual earnings per share with annual dividend per share. An alternative way to get the same ratio is to divide net income with the total dividend paid.
In essence, DCR shows investors how many times a year a company pays dividends to shareholders. This is important if the company offers both common and preferred stock because the DCR will not be the same for all shareholders.
Shortcuts to choosing dividend stocks
As you can probably imagine, each investor puts a disproportionate amount of focus on a certain type of data, so compiling an exhaustive list of company performance metrics is almost impossible. For example, there are schools of thought that overstate the importance of figures that closely describe dividends (like P/E or price-to-earnings ratio, dividend yield, or payout ratio) when choosing stock. Others look at increasing profit margins of companies or dividend taxation, etc. To each their own.
There is a shortcut to this analytical mess. It’s known as the Dividend Kings – a group of companies that have not only paid but also increased their dividends for 50 consecutive years. And then there’s the more forgiving list of Dividend Aristocrats – a group of companies that have done roughly the same for only half of that time. Of course, these lists don’t imply that you should throw all other metrics out the window.
However, keep in mind that there is much more to collecting returns on dividend stock than simply making your preferred pick.
The tax on returns from dividends is an important factor when selecting dividend stocks because it can reduce your income stream. Of course, an investor might intentionally open a specific account (tax deferred) to avoid excessive taxation, as long as this is within their legal rights. At the same time, those investors that use their retirement accounts aren’t even subject to tax.
Let’s have a closer look.
Qualified dividends vs non-qualified dividends
Since 2003, dividends that meet a specific set of criteria are known as qualified and are taxed as long-term capital gains. For those of you that are not familiar with dividend taxation, this tax rate is from 0% to 20%, depending on the investors’ tax bracket. The non-qualified dividends are subject to the ordinary income tax rate, which can be considerably higher (up to 37%).
Keep this in mind when choosing investment opportunities, since some offers that promise high returns (for example, high dividend yield) can also carry unfavorable tax obligations.
Investing through a tax-deferred account allows for tax-free growth of returns. This is typically done by investors who wait to become retirees to pay these taxes (and thus qualify for a lower tax bracket). Some of the retirement plans like IRA allow returns from dividend stock to be exempted from tax. However, do check this before each investment because it’s not always the case.
How does the collecting of returns work?
As we already mentioned, the most common dividend payment interval is each year. The period between two payments can vary depending on company policies and can also be monthly, quarterly, or biannually. Sometimes, an extra dividend is shared to mark special occasions like anniversaries or a big success for the company.
Dividend payment dates
There are four dividend payment dates investors should be aware of: announcement date, ex-dividend date, record date, and payment date. The first and the last (announcement and payment date) are of no great consequence because they simply mark the moments when the company notifies shareholders about forthcoming dividends or about the date on which dividends will be actually transferred to accounts.
Ex-dividend date vs date of record
Ex-date and date of record are much more important, especially since the eligibility for receiving dividends depends on the dates at which transactions (buy/sell) were completed. The ex-date marks the date up until shareholders are entitled to dividends. For example, if an investor buys dividend stocks after the ex-date, they will not receive payments. Similarly, investors that have sold their dividend stocks before the ex-date will receive payments.
The date of record is the actual cut-off date. In simple terms, this is the date at which the company checks its records to determine how many shareholders are due a dividend. The date of record is one business day after the ex-date.
Investors usually can collect returns in one of two ways: as cash dividend or as stock dividend.
Cash dividend means that money is transferred to your brokerage account and you can use it at your liberty. However, returns in the form of stock dividends allow investors to reinvest the gains and get more stock from the same company. This is also known as a dividend reinvestment plan (or a DRIP program) and it’s a very popular practice. The promise of compounded returns over a long period of time is the prime motivation behind this, although tax benefits play a role as well (returns from domestic companies are taxed as long-term capital gains). There is more than one dividend reinvestment strategy, of course, but most of them keep your money tied up in the market.
Drip tips and strategies
Reinvesting dividends makes for a strategy that will keep investors focused on long-term financial goals. If shareholders have set up a DRIP program, they are less likely to cave in to fear caused by short-term volatility. Also, DRIPs resemble dollar-cost averaging strategies, which in turn positions investors away from attempts to time the market.
Although most of these perks are beneficial for investors, such strategies don’t imply that you should simply go for blue-chip dividend stocks on autopilot. Two major issues with DRIPed dividends are taxation and fees (or brokerage commissions). So, those of you that are interested in reinvesting dividends should do the due diligence on each separate stock. In addition to this, diversifying stocks across up to seven different industries is a recommended risk mitigation tactic. Of course, holding as much stock as possible (some would advise holding more than 20 different stocks) will also serve as a buffer from losses.
Risks of investing in dividend stocks
Savvy financial analysts argue that investing in dividend stocks combines the worst of both stocks and bonds. It leaves investors exposed to almost all of the risks associated with stocks while promising the returns of bonds. Indeed, companies can go out of business at any moment. Only, if you hold common stock, it’s generally easier to find a greater fool willing to buy them, while getting rid of dividend stocks can prove much more difficult.
The greatest vulnerability of dividend stocks is the fact an investor doesn’t have control over a company’s dividend policy. These things have happened in the past, and can happen again – there are many examples of companies stopping dividend payment.
High-yield dividends are particularly susceptible to change in interest rates, and inflation can diminish returns in the long run. As with any other investment, weighing out the risks is a crucial part of the equation.
Dividend stocks are a viable option for collecting returns, particularly if you, as an investor, are focused on long-term gains. The hard work mostly revolves around choosing the companies that inspire confidence and which you feel comfortable investing in. Diversifying your portfolio is always a good idea, so make sure you look into dozens of companies. And the rest is easy, just be mindful of taxation and have a clear goal in mind.