Investing in dividend stocks remains an attractive option for equity investors. You can benefit from a steady stream of passive income as well as capital appreciation over the long-term.
A dividend is a cash or stock payment that a company issues to its stockholders from its earnings. It is like a ‘thank you note’ from companies for holding their stocks. Dividend investment may seem like an easy method to grow money over time but it is a lot more complicated than it looks.
Dividend investing is a strategy of buying stocks that pay dividends in order to receive a regular income from your investments. There are different strategies one can use to start investing in dividends. To get maximum returns through this type of investing, the key is to select the right stock.
Companies primarily issue dividends in cash and/or stocks. A stock dividend is a payment made to shareholders in company shares rather than cash. This payment can be made when a company wants to reward its shareholders but doesn’t have spare cash or wants to preserve cash for other investments. A cash dividend is the distribution of funds or cash to stockholders as a part of current earnings or accumulated profits.
According to Investopedia, if a company starts paying dividends, it sends a strong message to investors about its strength and potential in the market. You must be a shareholder of record on or subsequent to a particular date designated by the company’s board of directors in order to qualify for the dividend payout.
Like every other type of investing, before you step in to invest in dividend stocks, you should keep these 10 things in mind:
1. Dividend yield and stock price have an inverse relationship
Dividend yield is expressed as a percentage which indicates the amount a company pays out in dividends each year relative to its stock price and has an inverse relation with the stock price. Let’s take an example to understand this.
If you buy 100 shares of Enbridge at $40.81 per share, you have made a total investment of $4,081. The company pays a dividend of $3.24 per share which means your annual dividend is $324. The annual yield is the total dividend amount divided by the cost of buying the stock ($324/$4,081) i.e. 7.94%.
From this we know that if the stock price moves higher, the yield drops and vice versa. Often a high dividend yield is result of a company that is in decline or about one that is going through a rough patch. Thus, you should keep a lookout on companies that pay decent dividends but more importantly have potential for long-term revenue growth.
2. The ‘Buy and Forget It’ stocks
No matter which strategy you use to invest in dividend stocks, you need to have a long-term approach. You need to identify companies that have a history of increasing dividends consistently over time.
For example, if you held 100 Enbridge shares back in 2000, you would have earned less than $40 in annual dividend payments. Enbridge has increased its dividends at an annual rate of 11% in the last 25 years which would have helped buy-and-hold investors generate significant wealth.
3. Higher dividend yields aren’t always a good sign
We know that stock prices and dividend yields move in opposition to each other. Higher dividend yields tend to attract investors but before you invest in it, you should always check if there is a large difference between the dividend yields of companies part of the same sector.
For example, if a stock you are looking at yields at 6% and others of the same industry are around 3-4% then there may be some risk involved in investing in that stock. Investors should consider the company’s future growth metrics, payout ratio, and other fundamentals before making an investment decision.
4. Pay attention to Dividend dates
According to Dividend.com, most common mistake investors do is that they don’t buy or sell stocks at the correct time in order to avail or forfeit an upcoming dividend.
There are four important dividend dates. The declaration date is the day the company declares it will pay a dividend. The ex-dividend date is the day buyers of this stock will no longer receive the declared dividend.
On the record date, the company decides who gets the dividend and on the payment date you actually get paid. Now, the key date for investors is the ex-dividend date. Investors will notice that the stock price is adjusted downward to account for the upcoming payout. So, if you want to receive a company’s next dividend payout, you should ideally buy one day before the ex-dividend day.
5. Payout ratios are important to consider before investing
The dividend payout ratio is expressed as a company’s annual dividends per share divided by its earnings per share. The dividend payout ratio can tell you a lot about the company you are considering investing in.
This number gives you an idea of how much breathing room a company has. Generally, good companies avoid dedicating too much towards dividends which leaves them with enough cash flow to fund R&D projects, repay debt or fund other growth opportunities.
No company should pay more in dividends than it earns. As a rule, a payout ratio over 70% should make investors wary. Only some companies in the utility and real estate sector are able to maintain high payout ratios due to a steady stream of cash flows.
6. Dividend reinvestment plan (DRIP)
A dividend reinvestment plan (DRIP) means that an investor’s dividend is reinvested in the company with the purchase of additional shares of the company, rather than receiving a cash payout.
This is a great way to build capital over long holding periods. Many individual companies as well as brokers give you this option. DRIP is convenient but not free. If the dividend comes from a stock held in a taxable account it is still fully taxable.
7. Is dividend investing a safe investment option?
Dividends are generally paid by companies that are well established and have a steady cash flow albeit with a few exceptions. This often leads investors to think that because a company is well established and pays a regular dividend to investors, it is a safe bet.
This may or may not be true. A lot of times, companies can use dividends to placate frustrated investors when the stock isn’t moving. So, to avoid falling into this trap it is necessary to know why the company is paying dividends and if these payments are sustainable
8. Dividend payments are not a guarantee
Companies decide to pay dividends on a monthly, quarterly or annual basis. This can also be a one-time payment if they wish to reward their shareholders. But it is important to note that dividends are not guaranteed.
During an economic downturn or recession or any other reason, companies can reduce or even stop paying dividends to their investors.
They can also stop or reduce dividend payments because of a big merger or a major development project that the company is looking to invest in. Generally, if a company stops paying dividends investors tend to opt-out of the investment but you should always take decisions based on the company’s overall health and future plans.
9. Dividend investing and value investing are Not the same
According to Dividend.com, there is a misconception that value investing and dividend investing are two same investment strategies. Value Investors consider price-to-earnings ratio, price-to-book ratio, and other similar ratios while dividend investors look for different metrics such as dividend yield, payout ratio, etc.
The goal of value investing is ‘Buy Low, Sell High’ and dividend investments emphasize identifying businesses with sustainable cash flow over the long haul. Though both may seem similar and have their own benefits, they are not the same and you have the freedom to choose the type of investing you want to opt into.
10. Yes, technology stocks pay dividends
Rewinding a little into the past, technology companies are not the go-to place for dividend investors because tech companies generally need to re-invest for growth or in research and development to stay ahead of the competitive curve.
But recently, technology giants including Apple and Microsoft pay reasonable dividends to their shareholders. According to MotleyFool, solid business models result in strong balance sheets that help companies sustain and grow dividends.
For example, Broadcom is a leading smartphone chip supplier, an industry that has grown at a staggering pace. This has helped the semiconductor giant to increase dividends by a stunning 4500% since 2010.
The Bullish takeaway
Dividend Investing is very rewarding if you invest after studying and taking every possible risk into consideration. It is a great way to grow investments slowly and build massive wealth over the long-term. You should consider all the points mentioned above as they can make a significant impact on your investment decisions.