Dividend stocks are an attractive option for many different investors: those just starting out and hoping to earn more income over the long haul, those hoping to build a retirement fund, and those already retired and seeking a regular income from dividends to replace work income.
Dividend investing is more than a source of steady income. It is also a cushion against volatility. And although past performance doesn’t guarantee future results, over the decades dividend stocks have consistently outperformed the returns of the S&P 500 index.
Use this guide to understand why dividend investing can be a great long-term strategy.
What Is Dividend Investing?
A dividend is “a share in a pro rata distribution (as of profits) to stockholders” (Merriam-Webster). Dividends are how a company directly rewards its shareholders.
Dividends primarily consist of cash payments for each share of stock that you own. If a company pays a $0.50 quarterly cash dividend per share of its stock, you’ll receive $200 annually if you own 100 shares.
A company may also issue dividends in the form of additional shares: stock dividends.
Dividend investing, then, simply means a form of investing in which an investor buys stocks that pay regular dividends and thereby provide a regular stream of income. The dividend income is separate from any gains in the value of the stock that strengthen the investor’s portfolio.
How Dividend Stocks Work
Dividends are one of the most direct ways that publicly traded companies can share their profits with shareholders. Although companies often pay dividends in cash, they may instead distribute additional shares in the company or property dividends in the form of assets.
Companies are not legally obligated to pay dividends. A company distributes them at its own discretion—which means the discretion of its board of directors, who must give approve the distribution.
A company planning to pay dividends to its shareholders must pay attention to the following dates:
- Declaration date. The declaration date is the date on which the firm’s board of directors announces the amount of the dividend, the date of record, and the date of payment.
- The date of record. The date of record is the date on which you must be a shareholder in order to receive the declared dividend. When you order a security, there’s usually a brief delay—perhaps of two days—before you formally become a shareholder.
- The date of payment. The date of payment is the date on which eligible shareholders receive their dividend payments. Depending on the instructions provided to your brokerage account, the money may appear as cash in your account or may be reinvested in the corporation that issued the dividend.
Most companies that distribute dividends do so on a quarterly basis. However, any company can change its dividend policy as well as the amount of a dividend and the frequency with which it issues dividends. Young and growing companies rarely distribute dividends, instead choosing to plough profits back into growth.
What Is a Dividend Yield?
The dividend yield is the ratio of a corporation’s annual dividend to its current share price. An annual dividend consists of the total dividends issued during a financial year, the most recent dividend issue multiplied by four (to reflect four financial quarters), or the total sum of dividends per share paid over the last four quarters.
Let’s look at how we can calculate the dividend yield:
Dividend yield = annual dividend / stock price
Assume that company ABC issues an annual dividend payout of $0.80 per share and that its stock is trading at $40. Dividing the company’s annual dividend of $0.80 by the share price of $40, we find that the dividend yield will be 0.05 or 5%.
A higher dividend yield may mean that a company is handing over an unusually large amount of money to its shareholders relative to its current share price. A relatively high yield may seem very attractive. But before you buy the company’s stock, try to learn why it’s so high.
- A company may increase its dividends as the stock value increases in order to maintain a competitive dividend yield. In this case, a high yield signals abundance of capital, strong earnings, and a strong company.
- When a company’s stock price plummets, the dividend yield may increase if the company maintains the current dividend. In this case, the high yield may snare you in a losing proposition if you miss the fact that the company has lost a lot of market capitalization because of a plummeting share price.
- Keep an eye out for companies that use debt to sustain their quarterly dividend payments. This is a warning sign that the cash flow may be slowing to a trickle.
A high dividend isn’t always evidence that an investment has good potential. Depending on the reason, it may be a good sign or a bad sign.
Dividend yields often change most in response to fluctuations in the company’s stock price rather than in response to fluctuations in the dividend value. If you’re looking for a stock that pays high dividends, look for these attributes in companies with high dividend yields:
- Mature. More established and stable companies tend to have higher dividend yields. They are often consumer companies that enjoy steady demand for their products, a demand that isn’t much affected by seasonal changes.
- Persistently popular. Certain successful companies sell products and services that many of us use and use often, staples that we are reluctant to drop from our budgets even when the economy is weak or our personal finances are weak.
- Bound by income regulations. Organizations like real estate investment trusts (REITs) and master limited partnerships (MLPs) are typically set up in such a way that they must pass on most of their income to shareholders.
Dividend Reinvestment Plans (DRIPs)
A dividend reinvestment plan (DRIP) enables you to use the dividends that a company pays you to automatically purchase shares in that company.
These plans are often offered by brokerage firms, and you can choose how much of the dividend that you want to use to buy the additional shares. Some companies offer dividend reinvestment plans to their shareholders directly, without using a broker.
How Dividend Reinvestment Plans Work
A dividend reinvestment plan automates reinvestment in a company you believe in. Once you are enrolled, you don’t have to manually make any trades in order for the reinvestment to happen. Without a DRIP, to reinvest a dividend you must calculate how much you can buy and place the order yourself. With a DRIP, your shares grow without your further intervention.
Here’s an example of how a DRIP works:
- Let’s say you own 10,000 shares in company ABC.
- You’ve enrolled in its DRIP so that 100% of your cash dividend is routinely reinvested.
- ABC announces a common stock dividend of $0.10 per share, with the company shares trading at $20 each.
- You can expect to receive $1,000 in the form of a cash dividend (10,000 x $0.10).
- Since you’re enrolled in the DRIP, you receive 50 new shares ($1,000/$20 = 50), which will increase your total holding to 10,050 shares.
Thus, not only is your money invested for you automatically, the value of your investment is also compounded over the long haul.
Arranging for your dividends to be reinvested automatically means that you profit from a company’s persistent success. The compounding effect is very attractive when the stock price appreciates. But keep the flip side in mind too. You will have to deal with compound losses if the company’s stock value plummets.
Although a DRIP can be a reliable way to reinvest in a company over time, it’s a good strategy only if you have a strong belief in the value of the company that will see you through ups and downs over a span of years. A DRIP may not be the best way to invest if you’re constantly shifting your money from one stock to another or if you plan to exchange all of your stocks for cash in the near future. DRIPs are a strategy for the long run.
We recommend that when adopting a DRIP strategy, you start with stocks that you already own and regard as solid investments. If you are already investing in several companies, ask your brokerage if it offers DRIPs. In most online brokerage accounts, you can set up a dividend reinvestment plan with the touch of a button.
Do Dividends Have a Place in Your Portfolio?
Of the many reasons to have dividends in your portfolio, one of the most persuasive is that high-yield stocks have tended to exhibit more sustained dividend growth and greater stability than other stocks.
In addition to stability and security, dividend stocks offer the following:
You invest to make money. Dividend-paying stocks offer the best of both income-generating worlds: potential for capital gains and regular dividend income from dividend payments sent to your bank account. There’s no need to make tough decisions about which stocks in your portfolio to liquidate when you’re making money from (hopefully) all of them.
Some companies let you acquire additional shares in cash at a discount. The discount can have a huge impact on your portfolio’s performance. Discounts ranging from 1 percent to 10 percent, combined with the lack of commissions for DRIPs, can help you obtain additional stock holdings at rates much better than those paid by investors who buy shares in cash through an online brokerage.
Stocks that pay dividends tend to be much less volatile than stocks that don’t pay dividends. Such stocks also pay higher returns on average, reducing your risk while providing a healthier, more stable portfolio.
Dividend-paying companies often boast more robust business models and higher-quality earnings. Only businesses with high-quality earnings can sustain a regular dividend each quarter. You should be able to count on the capabilities of the dividend-paying companies you invest in.
An all-dividend strategy is a very practical approach to investing over the long haul, especially if you want to build your assets for retirement. Even so, bear in mind that the effectiveness of the strategy largely comes down to the quality rather than the quantity of dividend offerings. A high-dividend yield may or may not be consistent with the degree of risk you can tolerate and with your overall investment goals.
Frequently Asked Questions
Do you have to pay taxes on dividends?
Personal income taxes are charged on dividends, which are proceeds of corporate earnings that have already been subjected to taxation. To avoid double taxation, Canadian taxpayers who own dividend-paying stocks may receive a tax break; they may be eligible for dividend tax credit. Dividend tax rates are typically lower than a similar amount of interest income.
Are dividend stock investments risky?
Like other kinds of stock investments, dividend stock investments carry some risk. For starters, no company is legally obligated to pay out dividends. If a firm must cut its expenses, your annual dividend payout may be at risk.
You could also lose money if the share prices drop, which can happen with any type of stock. Worst-case scenario: the company goes belly up before you can liquidate your shares. Luckily, you can mitigate these risks by creating a diverse portfolio of dividend-paying stocks and non-dividend-paying stocks.
Are dividends better than interest?
It all comes down to your financial goals and overall investment strategy. High-dividend stocks can provide a stream of income, but this stream isn’t guaranteed. On the other hand, investing in stocks that do not pay dividends may give you a well-diversified portfolio as well as high returns on investments in companies that prefer to reinvest earnings in research and development. And unlike dividends, capital gains are often not subject to taxation.