Investing in Dividend Stocks

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Investing in dividend stocks may be considered as part of the goal to building long-term wealth. If you are interested in learning more about dividend stocks, this article may be helpful.

What are dividend stocks?

Dividends are a type of payment used by companies to share profits with their shareholders. Dividends may be paid out on a monthly, quarterly, semi-annual or annual basis, which is one way for investors to earn a return from their investment. This article can help you better understand dividend stocks.

What are dividends?

Dividends are payments made by companies to their shareholders based on the number of shares they own.

Dividends are usually paid when a company has excess cash that is not being reinvested into the company. This excess cash is divided up among shareholders and paid out to them.

How do dividends work?

If a dividend is announced, qualified shareholders are notified through a press release, which usually includes the following information:

  1. The Declaration Date, which is the date the dividend is declared by the board. The announcement will include the dividend amount, the Ex-Dividend Date, the Record Date, and the Payment Date.

  2. The Ex-Dividend Date, which is the date the stock no longer trades with the dividend. If you purchase shares on or after the Ex-Dividend Date you are not entitled to the upcoming dividend payment. Typically, the Ex-Dividend Date is set to one business day before the record date.

  3. The Record Date, which is when companies review the list of shareholders to determine who is eligible to receive the upcoming dividend payment. To be on the company's books by the Record Date, an investor must purchase the stock at least two business days before the Record Date, due to the T+2 settlement rule in most markets (where transactions are settled two business days after the trade is made).

  4. The Payment Date, which is the day shareholders will receive the dividend payment

Dividends are often paid quarterly, but can be paid out on other frequencies (or even as a one-time payment, for special dividends). The amount received depends on the number of shares you own in that company.

For example, if you own 100 shares and are paid out $0.50 for every share, you may get $12.50 every quarter – or $50 annually.

To qualify for a dividend payout, you must be a “Shareholder of Record”. That means you must already be listed as one of the company’s shareholders on the Record Date.

Dividend payouts are usually in relation to the overall financial health of the company, as well as the price at which their stocks/shares are trading.

When there is a high-value dividend, it may indicate that the company is financially healthy and pulling a good profit.

However, high-value dividends may also point to signs that the company has no future projects planned and is using this cash to pay shareholders (rather than reinvesting it).

For companies with an established history of dividend payments, any significant reductions to the dividend amounts, or the elimination of dividends altogether, may be a warning about the company’s financial health. On the other hand, it might be a signal that management has a plan to reinvest that money into the growth of the company. That is why it is important to research the companies you’re considering investing in.

How to evaluate dividend stocks?

Investors can calculate several key ratios to assess the stock's dividend reliability and attractiveness. These ratios include:

  1. Dividend Yield: This is a ratio that shows how much a company pays out in dividends each year relative to its stock price. It's calculated by dividing the annual dividends per share by the price per share. This can give you a rough idea of how much income you might receive for each dollar invested in the company. A higher dividend yield can be attractive, but it's important to ensure that the high yield is sustainable.

    In some cases, some people may spend all their energy on what the dividend yields have been, rather than the fluctuation of the stock price. This is a very narrow view, since stock prices are related to a company's performance.

    When a stock’s value grows, the demand for those stocks often grows with it. As the law of supply and demand suggests, when demand goes up, the price does too. Since the dividend isn’t directly related to the stock price, the dividend yield (calculated by dividing the annual dividends paid per share by the price per share) technically falls. 

  2. Dividend Payout Ratio: The payout ratio indicates what proportion of earnings a company pays to shareholders as dividends. It's calculated by dividing the annual dividends per share by the earnings per share (EPS). This may be an indicator of how feasible their dividend policy is. A lower payout ratio (e.g., 10% - 30%), could signal that the company is retaining more earnings for growth, while a higher ratio can indicate a strong commitment to paying dividends. However, extremely high payout ratios (e.g., 55%-75%) may not be sustainable.

  3. Dividend Growth Rate: This ratio measures the annualized percentage increase in a company's dividend per share. Consistent dividend growth over time can be a sign of a company's health and stability.

  4. Dividend Coverage Ratio: This is similar to the payout ratio but focuses on cash flow. It is calculated by dividing the company's operating cash flow by the total dividends paid. This ratio indicates how well the company’s cash flow supports the dividend payments.

  5. Earnings Yield: This is the inverse of the price-to-earnings (P/E) ratio. It's calculated as earnings per share divided by the price per share, and helps investors compare the return on investment from dividends to other investment opportunities.

  6. Price-to-Dividend Ratio: This is the ratio of the company's current stock price to its annual dividend payout. It's useful for comparing the dividend performance of different stocks.

  7. Debt-to-Equity Ratio: While not a direct dividend ratio, it's important to consider a company's debt level. Simply divide the company’s total debt (lines of credit, bank loans, etc.) by the company’s total assets (property, equipment, etc.). This type of information can usually be found in annual reports of publicly traded companies. A high debt-to-equity ratio might indicate a riskier investment and can impact a company's ability to maintain dividend payments.

Each of these ratios can provide valuable insights, but they should be used in conjunction with a broader analysis of the company's overall financial health, business model, and industry trends. It's also important to compare these ratios against industry benchmarks and historical performance.

You may also look at their past dividend payout trends. Has it doubled over the last couple of years, or has it been slowly declining?  How much has it been fluctuating, if at all? Get a hold of the company's annual report, spend some time on their website, and immerse yourself in their business model to help understand their growth plan. Keep in mind, there’s no guarantee that a company will pay dividends. Take 2020 for example: While some companies with strong balance sheets were able to successfully weather the economic slowdown we experienced, even some of the best businesses had to slash dividends during the pandemic in order to save cash. 

Remember, dividend stocks are not government bonds, which guarantee the return of your principal.  Bondholders are paid out of operating capital, whereas shareholders are paid out of profit. As a result, dividend stocks are subject to macroeconomic and company-specific risks.

Pros and cons of investing in dividend stocks

Pros of Investing in Dividend Stocks

Potential for incremental income: Dividend stocks can provide investors with a reliable source of income. While no investment is guaranteed, the incremental income offered by dividend stocks can help ensure you earn at least a partial return on your investment, and if the company’s profits increase year over year, the dividends paid to you may increase as well.

Some companies may also offer a Dividend Reinvestment Plan (DRIP). Instead of receiving cash payments, dividends are paid to you in the form of additional shares. The additional shares are purchased for you automatically, so you won’t have to pay any commission fees.

Tax credits: Dividend payments are considered a tax-efficient source of income. That’s because payments provided by qualified dividends are taxed at significantly lower rates than income earned from other sources.

Helps in stock evaluation: Companies that pay dividends tend to have good cash balances and as a result, may be considered financially healthier by investors.

Investors often use a company’s current and historical dividend payment as a reliable benchmark for a company’s financial health. In fact, some investors view a company’s ability to pay dividends as a better indicator of a company’s growth and profitability than changes in a company’s stock price. This can help dividend stocks retain more of their value among investors during economic downturns.

Reduces risk and volatility: Profits earned by dividend payments can help mitigate losses if stock prices decline, which may help investors reduce volatility and risk within their portfolio.

Cons of Investing in Dividend Stocks

Limited potential for gains: Dividend stocks don’t typically offer significant growth. That’s because high growth companies are more likely to reinvest earnings back into the company instead of paying significant dividends to shareholders.

Dividends are not guaranteed: No investment is ever guaranteed. Companies will only pay dividends to investors when they have profits to share. If a company’s profits decline, dividends paid to shareholders are likely to decline as well.

Dividend yield traps: Dividend yield traps, or dividend traps, occur when a company’s dividend yield makes them appear to be a better investment than they actually are. If a company’s dividend yield is too high, it’s probably unsustainable and likely to decline.

Frequently asked questions

Do ETFs pay dividends?

If the stocks held within an Exchange-Traded Fund (ETF) pay dividends, those dividends will be passed on to investors. You can also invest in a dividend ETF. Dividend ETFs include a portfolio of dividend paying stocks chosen by the portfolio manager and are usually designed to track a specific dividend index.

What are stock dividends?

Stock dividends are dividends paid to shareholders in the form of shares instead of cash. Companies often choose to pay stock dividends to shareholders when they have limited liquid cash available.

What are the rules for paying dividends?

Cash dividends reduce a company’s Retained Earnings and Cash account balances. As a result, companies can only issue cash dividends when they have sufficient cash on hand and retained earnings available.

Does it matter when you buy a dividend stock?

You need to own a stock before the Ex-Dividend Date to receive the next dividend payment. If you buy a stock on or after the Ex-Dividend Date, you won’t be eligible for the next payment. The dividend will be paid to the seller of the stock instead. However, the price you pay for the stock will typically be reduced to reflect the dividend payment being provided to the seller. As a result, while you’re not eligible to receive the next dividend, you’ll at least be able to buy the stock at a lower price.

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