What do you think about when you hear the word investing? Do you get excited about researching and analyzing stocks? And not just any stocks, but stocks that you can buy and then passively watch grow over time? And not just grow, but grow in a way that lets you live the life you’ve always imagined, just from the passive income stream these stocks provide.
If any or all of these statements apply to you, then dividend investing may be just the type of investment plan you're looking for. In this article, we'll define what a dividend stock is, some strategies for dividend investing, we'll get you familiar with important terms like the ex-dividend date and break down whether a Dividend Reinvestment Plan (DRIP) is right for you.
What are dividend stocks?
Dividend stocks are stocks issued by companies who redistribute a portion of their profits to their shareholders on a regular basis. This dividend is usually paid in cash, although sometimes it can be issued as additional shares of stock. Dividends are typically issued quarterly.
If you were to define dividend stocks in a word, you might say “dependable” or “steady”. They certainly don't offer the same high-risk, high-reward appeal that many investors look for. However, the investor that maps out a dividend investment strategy will be rewarded with companies that have sound balance sheets, are in sectors that offer stability and growth (think Wal-Mart or Coca-Cola), and will take pride in rewarding their shareholders. The best of breed actively seek to increase the value of their stock as well as their dividend.
A dividend announcement signals that a company has a business model that is allowing it to provide income for its shareholders in a sustained fashion. Paying the dividend creates some price stability for the stock and as an investor; you get tangible evidence of a stock’s performance.
Dividend stocks have always held a certain appeal to investors. In fact, it used to be said that a company existed to pay a dividend to its shareholders. Many investors (and CEOs for that matter) would chuckle at that today, but there are many companies that still believe in distributing a share of their profits to their shareholders.
That being said, the relative predictability of dividend stocks makes them boring for some investors. For these investors, dividend investing fell out of favor during the 1990s. However, they have returned to favor in recent years. A couple of factors explain this:
First, many investors have learned their lesson from the bubbles of the last 20 years. Dividend stocks represent a safer way for investors to invest their way to wealth.
Second, as anybody who has money in a bank knows, we live in a low-interest rate climate. While that may be good news for borrowers, it’s not so good for savers. There was a time when banks actually paid us interest for depositing money in their institutions. Technically they still do, but the interest rates they pay are paltry, particularly for individuals looking to grow their savings.
This is where dividend stocks come in.
How do dividend stocks provide me with income?
As we mentioned earlier, a dividend is a cash payment from a company’s earnings. The company decides how much of their profits will be given back to shareholders and makes a public announcement. Then on the assigned date, investors receive their dividend payment. The amount each shareholder receives is straightforward:
(Annual dividend) x (number of shares owned)
So for a quick example, in 2017, Coca-Cola issued a $1.48 dividend. If you owned 1,000 shares of their stock, you would have received an annual dividend of $1,480. Since their dividend is paid quarterly, this would be divided into four payments. So, in this example, you would receive $370 per quarter.
Obviously, the more shares you own the higher your dividend payment.
So, you think, I should look for companies that pay out the highest annual dividend. Got it.
Not so fast.
Before we go into explaining some strategies for investing in dividend stocks, we should explain the difference between an annual per share dividend and a dividend yield. To do that, let’s use another example:
- Company A announces a $2 per share annual dividend. The stock costs $150 per share.
- Company B announces a $1 per share annual dividend. Their stock costs $50 per share.
To calculate the yield, you would simply divide the announced per share annual dividend by the share price.
- For company A, that would be 2/150 = 0.013%
- For company B, that would be 1/50 = 0.02
Simply put, investing $100,000 in Company A would produce $1,300 of dividend income. That same $100,000 in Company B would produce $2,000. So, in this case, although Company A is issuing a higher per share dividend, you would get a higher yield from Company B.
How do I invest in dividend stocks?
There are essentially two ways to invest in dividend stocks. You can look for companies by yourself, or you can invest in one or more dividend exchange-traded funds (ETFs).
Option 1: Choosing stocks yourself
In this age of the internet, looking for stocks on your own has never been easier. There is a wealth of information on publicly held companies literally at your fingertips.
However, not all dividend stocks are ideal for your investing goals. This means you should have a strategy for selecting which dividend stocks to invest in. The strategy that is best for you depends largely on your investment objective. Do you want to maximize your current income, or are you more interested in long-term growth?
If maximizing current income in a reliable, regular way is your goal, you’ll want to look at dividend stocks that produce above-average dividend yields. As our example above showed, this is different from looking at what a company’s announced per share dividend is. This will provide the opportunity for you to generate the most income from your portfolio.
When you’re looking at yields, be sure to look at the company’s fundamentals. Particularly pay attention to the spread between their earnings and what they are paying out in dividends. A pattern of paying out more in dividends than is supported by earnings should call into question how sustainable their dividend is. If you are counting on the income from that high yield, and the yield is cut significantly, that will reduce the amount of income you receive.
While generating income is an inherent benefit of owning dividend stocks, in some cases, your goal may be to focus on long-term growth. What you're looking for with this strategy are companies that consistently raise their annual dividend payments. This is a strong indicator that a company has a solid balance sheet and a proven ability to generate a profit even when the economy trends downward.
One source of information is to look for members of the S&P Dividend Aristocrats. To qualify for this list, a company has to have raised their dividend payment every year for at least 25 years. Talk about consistency. As with any investment, past performance does not guarantee future results, and the yields you get from these companies are generally not among the highest. But the tradeoff is less risk and a higher degree of confidence in future performance.
Option 2: Investing in an ETF
Investing in a dividend ETF is a good option for beginning investors and investors who don’t want to take the time to choose their own stocks or track individual stocks once they buy them. A dividend EFT is typically comprised of multiple dividend-paying stocks. If you believe in the idea of not putting all your eggs in one basket, this may be a great option.
However, choosing an EFT can be like walking into a Baskin-Robbins. There are a lot of varieties and it’s still up to you to decide on which EFTs are right for you. You’ll want to look at the stocks that are included and check their dividend yield, their consistency with paying the dividend over time, their expense ratio (low is good) and the size of the company, or market capitalization. From lowest to highest risk, there are large caps, mid-caps, and small caps.
When will I receive my dividends?
The process for receiving your dividends is well defined, but it will vary from company to company. However, all companies must publicly list three milestones: they must declare their dividend, they must post a date of record (or ex-dividend date) and they must post the payment date.
The declaration date is just that. It’s the day that a company’s Board of Directors announces that it intends to pay a dividend. On the day they declare their dividend, the company must also announce:
The date of record ("ex-dividend" date). In layman's terms, this is the "drop dead' date for an investor to be a stockholder of record with that company. You must own shares of that company’s stock on or before the ex-dividend date to be entitled to the dividend. This date usually is several days before the payment date. However, you are entitled to the full dividend even if the purchase of your shares is completed on the ex-dividend date.
The payment date is the date that the cash is distributed to shareholders. In many cases, this can be done through an electronic deposit.
What if I want to reinvest my dividends?
One of the many benefits of dividend investing is the power of compounding. To show you the benefit of compounding let’s go back to our Coca-Cola example. If you owned 1,000 shares in 2017, you received an annual dividend payment of $1,480. If you were to reinvest that dividend at today’s share price (approximately $46) you could have purchased an additional 32 shares.
However, remember dividends are typically issued quarterly so you are actually purchasing 8 shares (plus fractional shares) every quarter, compounding your dividend payment. For the purposes of this example, let’s assume you purchase eight shares every quarter (ignoring fractions of shares).
Quarter 1 = 1.48 x 1008/4 =372.96
Quarter 2 = 1.48 x 1016/4 = 375.92
Quarter 3 = 1.48 x 1024/4 = 378.88
Quarter 4 = 1.48 x 1032/4 = 381.84
Also remember that this is assuming that the dividend stays the same, if you’re looking to buy companies who have a proven track record of increasing the value of their dividends, it’s not hard to see how an initial investment can grow.
The easiest way to reinvest your dividends is through a Dividend Reinvestment Plan (DRIP). These are offered by companies and allow you to automatically use the money you received from their dividend to buy more shares of their stock on the dividend payment date. Aside from the convenience, in many cases, DRIPs allow you to purchase shares without paying commissions and, in some cases; you can purchase shares at a discount.
Companies that offer DRIPs are doing so because they are selling the shares directly to investors, which allows them to reinvest the proceeds. DRIPs are also a way for a business to raise capital and reduce the expense of a dividend payment.
The primary disadvantage of a DRIP is that a shareholder must pay taxes on the dividend even if they do not receive the cash.
The bottom line on dividend investing
Like any investment strategy, investing in dividend stocks has advantages and disadvantages. The advantages are a reliable and predictable income stream that can potentially grow over time, the benefits of compounding your growth when you reinvest your dividends, and the relative peace of mind that comes from investing in financially stable companies in mature industries.
The disadvantages are that, because they choose to issue dividends, these companies are not prone to the potentially larger gains that an investor can achieve from aggressive growth stocks. You also run the risk of having a dividend be reduced or cut altogether which will affect the cash flow from your portfolio.
However, even the most aggressive investors can appreciate the benefits that dividend investing can offer and use these stocks as a hedge against losses in other areas of their portfolio.