Investing in dividends is a strategy that provides investors with two sources of potential profit: one, the predictable income of regular dividend payments, and two, the appreciation of capital over time. Buying dividend stocks can be a great approach for investors looking to generate income or for those simply looking to generate wealth by reinvesting dividend payments.
This strategy may also be attractive to investors seeking lower risk. Dividend-paying stocks may be some of the safest. But there may still be difficulties, and dividend stocks can be risky if you don’t know what to avoid.
Why invest in dividend stocks?
Whether you’re looking to generate income or build long-term wealth for the future, buying dividend-paying stocks can be an excellent investment strategy. This is due to the twofold nature of the way investing in dividends rewards investors: recurring dividend payments and capital appreciation.
Let’s see an example. Let’s say you buy 100 shares of a company for $ 10 each, and that company pays an annual dividend of $ 0.30. You would invest $ 1,000 and, over the course of a year, you would receive $ 30 in dividend payments. That translates to a 3% return, not too bad. What you choose to do with your dividends is up to you: you can reinvest them in company stock, buy stock in a different company, or buy pizza and a yacht. Regardless of whether the company’s stock price rises or falls, you receive those dividend payments as long as the company continues to make them.
Image source: Getty Images.
The beauty of dividend-paying stocks is that part of their returns includes predictable dividend payments. Not all dividend stocks can hold a payout in every economic environment, something the COVID-19 pandemic has shown, but a diversified portfolio of dividend stocks can get you rain or shine.
Combine those dividends with capital appreciation as the companies you own grow in value, and total returns can rival or even outperform the overall market.
Examples of dividend shares
Here are some well-known companies that have a history of dividend payments, listed along with their recent dividend yields and the amount per share of each dividend:
| Business | Dividend yield | Dividend amount |
|---|---|---|
| Cisco Systems (NASDAQ: CSCO) | 3.1% | $ 0.36 |
| Visa (NYSE: V) | 0.6% | $ 0.30 |
| The Warehouse of the House (NYSE: HD) | 2.32% | $ 1.50 |
Yield and dividend amount as of June 24, 2020. The dividend amount is the most recent quarterly dividend paid per share.
As you can see, dividend stocks can come from almost any industry, and the amount of the dividend and the yield can vary greatly from company to company.
Dividend yield and other key metrics
Before buying dividend stocks, it is important to know how to evaluate them. These metrics can help you understand the amount of dividends you can expect, how safe a dividend can be, and most importantly how to identify the red flags.
- Dividend yield: The annualized dividend, represented as a percentage of the share price. For example, if a company pays $ 1 in annualized dividends and the share is $ 20 per share, the dividend yield would be 5%. Performance is useful as a valuation metric (by comparing a stock’s current performance to historical levels) and identifying red flags. While higher dividend yield is better if all things are equal, a company’s ability to sustain dividend payouts and, ideally, increase it, is even more important.
- Payment ratio: The dividend as a percentage of a company’s earnings. If a company earns $ 1 per share in net income and pays a dividend of $ 0.50 per share, its payout rate is 50%. Generally speaking, the lower the payout ratio, the more sustainable a dividend should be.
- Cash dividend payment ratio: Net GAAP income is not a measure of cash, and various non-cash expenses can cause a company’s earnings and actual cash flows from operations to be significantly different from period to period, which can cause the company’s payment ratio is sometimes imprecise. The cash dividend payment index measures the percentage of a company’s operating cash flows, less capital expenditures, that it has paid in dividends. Investors can use this in conjunction with the payout ratio to get a better idea of the sustainability of dividends.
- Trotal return: The increase in the price of the shares (capital gains) plus the dividends paid. For example, if you pay $ 10 for a stock that goes up $ 1 in value and pay investors a dividend of $ 0.50, that $ 1.50 value you have earned is 15% on total return.
- EPS: Earnings per share. This normalizes a company’s earnings to value per share. The best dividend stocks are companies that have demonstrated the ability to regularly increase earnings per share over time, and therefore increase the dividend. A history of earnings growth is often evidence of lasting competitive advantages.
- P / E ratio: The price / earnings ratio divides the price of a company’s stock into earnings per share. The P / E ratio is a metric that can be used in conjunction with dividend yield to determine if a stock of dividends is valued fairly.
High performance is not everything
Inexperienced dividend investors often make the mistake of looking for the highest dividend yields. While high-yield stocks are not bad, high returns may be the result of a stock that has fallen because the dividend is at risk of being cut. That is a dividend yield trap.
Here are some steps you can take to avoid falling into a performance trap:
- Avoid buying stocks based solely on dividend yield. If a company performs significantly better than its peers, that’s often a sign of trouble, not opportunity.
- Use payout ratios to measure the sustainability of a dividend.
- Use a company’s dividend history, both pay growth and performance, as a guide.
- Study the balance sheet, including debt, cash, and other assets and liabilities.
- Consider the business and the industry itself. Is the company at risk from competition, weak demand, or some other disruption?
Unfortunately, performance that seems too good to be true often is. It is better to buy a lower yielding dividend stock that is rock solid than to pursue a high return that may be illusory. Furthermore, focusing on dividends increase – A company’s history and ability to increase the dividend – is often more profitable.
How are dividends taxed?
Most dividend stocks pay “qualified” dividends, which, according to their tax category, are taxed at a rate of 0% to 20%, significantly lower than ordinary income tax rates of 10% to 39.6% (plus a 3.8% tax on certain investment income for those who earn the most).
While most dividends qualify for the lowest rates, some are classified as “ordinary” dividends and are taxed at their marginal tax rate. Various types of stocks often pay high dividend yields and may have higher tax obligations due to their corporate structures. The two most common are real estate investment trusts, or REITs, and master limited partnerships, or MLPs.
Of course, this doesn’t apply if your dividend stock is held in a tax-advantaged retirement account, such as an IRA, with the caveat that some MLPs may leave you tax due even on your IRA.
Dividend investment strategies
If you are a long-term investor looking to cultivate your savings, one of the best things you can do is to use a dividend reinvestment plan, usually called Drip. This powerful tool will take every dividend you earn and reinvest it, without commissions or commissions, in shares of that company. This simple tool to set it up and forget it is one of the easiest ways to put the power of time and capitalization to your advantage.
If you are creating a portfolio to generate income today, it is important to remember that dividends are not mandatory for a company, as are interest payments on bonds. And that means that if a company has to cut expenses, the dividend could be at risk. With this in mind, it is important to build your income portfolio with a safety margin and to diversify between companies with different risk factors.
This will not completely eliminate the risks of a dividend cut, but it will reduce them while giving you a margin of safety to ensure you generate enough income. If this is your goal, focusing on high-quality companies with strong dividend growth records is much more important than buying higher returns that can turn out to be cheating.
