In both bull and bear markets, investors look for ideal pockets to place their capital. Depending on whether you are new to investing or a seasoned professional, investing in dividend-paying stocks can add certainty and a healthy income stream to your portfolio.
Contrary to popular belief, investing in dividend-paying stocks is not exclusively reserved for retirement investing. They are often associated with more mature portfolios and are terrific investments for adding diversity to your portfolio. Dividend-paying stocks can generate healthy returns through capital appreciation and dividend payments.
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What Are Dividends?
Dividends are payments made by a company to its shareholders. These payments are distributions, typically from a company’s earnings, approved by a company’s board of directors and made regularly, usually quarterly. Dividends can come in cash, additional shares, or other forms of payment.
A dividend payment is made to an investor to reward them for investing in the company’s equity. Companies can increase or decrease their dividend payments depending on the volatility of their business, whether the company wants to deploy their cash into value-generating business lines, or reward shareholders for holding their stock.
It is important to note that not all stocks pay dividends. If you want to invest in dividends, you will want to choose the best high-yielding dividend stocks.
Smart Tip:
Investing in dividend-paying companies can be a great way to hedge against high inflation because some companies increase their dividend payments to combat inflation.
Why Invest in Dividend Paying Stocks?
Investing in dividend-paying stocks is attractive for almost any type of investor.
As a young investor, you can utilize dividend stocks to invest in more established companies and begin building your passive income portfolio. Investing in mature companies allows you to take advantage of long-term capital appreciation and increase your net worth through increased earnings.
For older investors nearing retirement, dividend stocks can be crucial for a passive income retirement strategy. Dividends are never guaranteed, but many investors rely on regular dividend payments as part of their retirement income. The cadence of dividend payments can be an essential element of an investor’s retirement income thesis.
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Dividend stocks offer investors two attractive features that affect their total return on investment. The first feature is capital appreciation, or the difference between the price you paid for the stock and the selling price, and the second feature is dividend income. Both features make investing in dividend stocks attractive for almost any portfolio.
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Key Dividend Dates
Dividend distributions follow a standard choreography of events. There are important dates to know if you are investing in dividend-paying stocks to ensure you qualify and receive your dividend payment.
1. Declaration Date
Company management must declare (or announce) that they plan on making a dividend payment to shareholders. This is colloquially called either the declaration date or the announcement date. However, before the declared dividend is issued to shareholders, the board of directors must approve the dividend distribution and amount to shareholders.
Smart Money Insight: Why would the board of directors vote against a dividend distribution? If the board of directors believed that the company could invest the cash into a project that would yield a higher rate of return for shareholders, they would vote against a dividend payment. This would allow the company to grow faster, potentially producing more earnings and dividend distributions in the future.
2. Record Date
Once a company has declared a dividend, the company sets a record date. You must be a shareholder on the record date to receive a dividend. Practically speaking, companies use this date to send important company information to shareholders.
3. Ex-Dividend Date
This is also a very important date for investors looking to receive a dividend because the ex-dividend date is when dividend eligibility expires.
Said another way, the ex-dividend date is the day the company’s shares begin to trade without the benefit of the most recent approved dividend payment. If you purchase stock on the ex-dividend date, you are not eligible for a dividend unless the company makes a subsequent dividend declaration.
If you sell your shares before the ex-dividend date, you are also selling away your right to receive the dividend payment. Conversely, if you buy dividend stocks before an ex-dividend date and after a declaration date, you are entitled to receive the declared dividend.
4. Payment Date
This is a dividend investor’s favorite date because the company will issue payments to eligible shareholders. Typically, these appear as deposits in your online brokerage account. Dividends can then be used as income or reinvested.
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7 Types of Dividends
Companies can pay dividends in various forms. Here are the seven major types of dividend distributions:
1. Cash Dividend
Cash dividends are the most common type of dividend payment. Cash dividends are often paid monthly, quarterly, or annually and disbursed as cash deposits directly into your brokerage account.
2. Stock Dividend
Companies can also pay dividends in the form of additional shares in addition to, or instead of, cash payments. Stock dividend shares are deposited into your brokerage account.
3. Special Dividend
Unlike recurring cash dividends, a company can issue a non-recurring special dividend. These dividend payouts represent an atypical large distribution of earnings to shareholders. Special dividends can happen after an acquisition or accumulation of uninvested company earnings.
4. Scrip Dividend
When a company that typically gives dividends lacks the cash to issue their dividend, it can print a scrip dividend. A scrip dividend is a certificate from the company that allows the investor to redeem the certificate for shares or future dividends.
5. Liquidating Dividend
When a company is going through the business liquidation process, or winding down of its business, it may issue a liquidation dividend. A liquidation dividend is a terminal dividend to distribute the remaining cash or assets to shareholders.
6. Property Dividend
When a company does not have enough cash to issue to its shareholders, it may instead distribute property. This is considered a non-monetary type of dividend and is rarer to receive.
7. Preferred Dividend
Preferred stock is a class of stock that has different rights from common stock, such as higher dividend payments and are are the benefactors of better rights during a liquidation. As the name suggests, preferred dividends are issued to preferred shareholders.
Preferred stock can be cumulative or noncumulative. Cumulative preferred stockholders are paid ahead of other shareholders if the company has missed prior dividend payments.
The most common type of dividend to receive is a cash dividend. Companies that distribute this reward to their investors are generally more mature with high cash flow (to justify a steady flow of cash payments to investors without disruption to business operations).
Dividends and Taxes
Like most passive income, dividend income is taxable. However, if you have held your dividend-paying stock for more than 60 days before the ex-dividend date, you qualify for capital gains taxes on your dividend income.
Smart Tip:
Dividends have a tax advantage over fixed-income investments like bonds and high-yielding savings accounts because interest payments from these investments are taxed as ordinary income. However, high-yielding savings accounts don’t have stock market risk and are considered safer investments.
Dividend Metrics and Ratios
Many mature publicly traded companies have dividend-paying stocks. Investors must discern which stocks will make the best investments for their overall portfolio, risk appetite, and outlook on specific companies.
There are many investment methodologies to analyze, compare, and contrast when selecting which companies to invest in. Here are three common metrics used by dividend stock investors:
1. Dividend Yield
One of the best metrics to compare companies issuing dividends is a company’s dividend yield. A dividend yield is calculated by dividing the company’s annual dividend by its current stock price. Dividend yield is a popular metric because it normalizes dividends across many companies. As a result, it is a favorite metric of financial media, online brokers, and stock analysts.
It is important to note that dividend yield can fluctuate as both the dividend is increased and decreased, as well as by increasing or decreasing the stock price. Because the dividend yield and stock price are inversely related, as one goes up, the other comes down.
For example, Company A has a stock price of $100 per share. They issue a $5 annual dividend, giving them a dividend yield of 5%. Company A can increase next year’s dividend yield by increasing its annual payout by 20 %, bringing the dividend to $6, increasing its yield to 6%. Alternatively, their stock price could decrease to $82 per share, without any increase in dividend payout to bring their dividend yield to 6%. Understanding the driver of an increasing dividend yield is essential for dividend investing.
2. Dividend Payout Ratio
One of the best ways to measure a company’s ability to continue paying dividends, or its dividend payout safety, is to analyze its dividend payout ratio. This ratio compares the proportion of dividend payments to a company’s net income.
Companies that pay less than 80% of their net income to dividend distributions are generally considered safe investments because these companies have ample ability to continue operations and continue making dividend payments. However, companies that have 80-100% of their net income as dividend distributions may face trouble making their dividend payments if they experience a slight downturn in business.
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Companies transitioning into dividend-paying stock can accelerate their dividend growth steadily over time or maintain a recurring payment amount. Investors evaluating dividend-paying companies keep an eye on dividends per share, which is the dividend distribution for each class of capital shares in each period.
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What To Do with Your Dividends?
After your dividends are distributed to your online investment account on the payment date, you can utilize dividends in a couple of different ways.
Increase Your Income: Dividend payments can be a regular source of passive income. Investing in dividend-paying stocks is very popular for investors seeking financial independence or a source of passive income.
Increase Your Portfolio: Dividend reinvestment plans, or DRIPS, are popular among younger investors who want to defer their passive dividend income and immediately reinvest those dividends. This can help your portfolio grow quickly because your dividend savings are compounding.
Smart Summary
Investing in stocks is one of the best ways to grow your net worth. Your investment strategy should dictate the percentage of your portfolio dedicated to investing in dividend-paying stocks. A dividend strategy is an essential component of a well-balanced portfolio and can change over time, depending on your portfolio’s risk profile. Dividends can add a regular source of passive income and allow you to accelerate portfolio growth.
