The idea of collecting checks for the rest of your life and generating passive income can be very compelling.
Dividend investing is a strategy that offers investors two sources of potential profit: the predictable income from regular dividend payments and capital appreciation over time. Buying dividend stocks can be a great approach for investors looking to generate income or those simply looking to build wealth by reinvesting dividend payments.
It can also be appealing for investors looking for lower-risk investments, which can often be found in dividend stocks. But like all investing there can be pitfalls along the way, and dividend stocks can be risky if you don’t know what you’re doing.
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Why invest in dividend stocks?
Whether you’re looking to generate income from dividends, which are payments a company issues to shareholders, or build long-term wealth for the future, dividend investing can be an excellent way to profit from stocks while also reducing some of the volatility that comes along with stock investing.
Let’s look at an example. Say you buy 100 shares of a company for $10 each, and that company pays a $0.35 annual dividend. You would have invested $1,000, and over the course of a year, and would have received $35 in dividend payments. That works out to a 3.5% yield, not too bad. What you choose to do with your dividends is up to you: some spending money, reinvested automatically into more of that stock or maybe a different stock. Regardless of whether the company’s stock price went up or down, you receive those dividend payments so long as the business is able to support them.
The beauty of dividend stocks is in the predictable nature of at least part of your returns, particularly if you own a diversified collection of dividend stocks across industries and risk profiles. Then you can factor regular dividends into your portfolio and choose how to best utilize them.
When you combine dividends with potential long-term capital appreciation as the companies you own grow in value, the total returns from dividend stocks can rival — and even exceed — the average returns you can expect from the rest of the stock market. Just ensure you buy established companies and don’t get too caught up in chasing the highest yield dividends, more on this later.
The Power Of Dividends
Dividends make up a significant portion of a stock investor’s total profits in the last 50 years. Taking a look back to 1970, about 78% of the total return of the S&P 500 Index can be attributed to reinvested dividends and the power of compounding.
Historically, dividends have proven themselves a potent source of total return in diversified investment portfolios, particularly during periods of market turbulence.
Look at the table below that shows an analysis of the prior eight decades of the performance of the stock market—that is, from 1930 to the 2000s. You can see that dividends often account for more than two-thirds of the total returns.
If investors avoided dividend-paying stocks during these periods, you can bet that they would have lost most of their overall gains. Without a doubt, dividend investing is an integral element to sustainable wealth building.
Dividend yield and other key metrics
Before buying any dividend stock, it’s important to know how to evaluate them. The following metrics will help you understand how much a stock pays, how safe it is, and whether you should avoid a particular dividend stock. For more general investing terms read: 40 Investing Terms You Need to Know
- Dividend yield — The dividend yield, expressed as a percentage, is the ratio that shows how much a company pays out in dividends each year relative to its stock price. For example, if a company pays $1 in annualized dividends and the stock is $10 per share, the dividend yield would be 10%. Yield is also useful as a valuation metric (for instance, by comparing a stock’s current yield to historical levels) and can be useful in identifying red flags. The key thing to note here is, while a higher yield is better, a company’s ability to maintain and grow the dividend payout matters even more.
- Payout ratio — The dividend as a percentage of a company’s net income. If a company earns $1 per share in net income, and pays a $0.50-per-share dividend, its payout ratio is 50%. In general terms the lower the payout ratio, the more sustainable a dividend should be.
- Total return — The overall performance of a stock, the combination of dividends and gains or losses from share price change. For example, if a stock rises by 7% this year and pays a 2.5% dividend yield, its total return is 9.5%.
- EPS — Earnings per share, is calculated as a company’s profit divided by the outstanding shares of its common stock. The resulting number serves as an indicator of a company’s profitability. In general, a company must earn more than its dividend in order to sustain it, and this metric normalizes its results to the per-share value. The best dividend stocks are companies that have shown the ability to regularly grow earnings per share over time. Companies that consistently grow earnings per share often have strong competitive advantages. The result is a company that can keep paying its dividend and potentially increase it.
- P/E ratio — The price-to-earnings ratio divides a company’s share price into earnings per share. P/E ratio is a valuation metric that can be used along with dividend yield to determine if a dividend stock is fairly valued.
High yield isn’t everything
Inexperienced dividend investors often make the mistake of looking for only the highest yields. While high-yield stocks aren’t bad, in many cases, high yields can be the result of stock price that’s fallen on expectations that the dividend will get cut, and when dividends get cut A LOT of investors get out driving the share price down as well. This is a dividend yield trap!
There are a few steps you can take to avoid falling for a yield trap:
- Avoid buying stocks based solely on the highest yield. A company that boasts a significantly higher yield than its peers may signal trouble.
- Use the payout and cash payout ratios to measure a dividend’s sustainability.
- Use a company’s dividend history as a guide.
- Study the balance sheet, including debt, cash, and other assets and liabilities.
- Consider the business and industry itself. Is the company at risk from competitors or weak demand? Many refer to this as having an economic moat, in other words a competitive advantage that gives them staying power in the their current place in the market.
A yield that looks too good to be true, sadly, often is. It’s better to buy a dividend stock with a lower yield that’s rock solid,than chasing high yield that may crash and burn. Moreover, focusing on dividend growth, a company’s history and ability to raise the dividend, can prove more rewarding than chasing yield.
How are dividends taxed?
Most dividend stocks pay “qualified” dividends, which, depending on your tax bracket, are taxed at a rate of 0% to 20%, significantly lower than the ordinary income tax rates of 10% to 39.6% (plus a 3.8% tax on certain investment income for the highest earners).
While most dividends qualify for the lower rates, some dividends are classified as “ordinary” dividends and are taxed at your marginal tax rate. There are several kinds of stocks that often pay above-average dividend yields that may also come with higher tax obligations because of 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 stocks are held in a tax-advantaged retirement account such as an IRA, with the caveat that some MLPs can leave you owing taxes even in your IRA. As always refer to your accountant or other tax professional for advice on your specific investments.
Dividend investment strategies
If you’re a long-term investor looking to grow your nest egg, one of the best things to do is use a dividend reinvesting plan, usually called a DRIP. This powerful tool will take every dividend you earn, and reinvest it (at no cost) back into shares of that company. This simple set-it-and-forget-it tool is one of the easiest ways to put the power of time and compounding work in your favor. This is easier than ever with major brokers and new offering DRIP investing.
If you’re building a portfolio to generate income today and won’t be able to reinvest every dividend, the best strategy might be identifying companies that pay an acceptable yield based on your income needs, with a solid margin of safety. Use the payout ratios and their historical results as a guide, as well as other valuation measures like P/E ratio to build a diverse portfolio of dividend stocks you will be able to depend on.
A Step-By-Step Guide to Understanding Dividends
If you’re new to dividend investing or just want a refresher course, my book Beginners Guide to Dividend Investing is the perfect place to start. It explains everything from the basics of terms and dates that matter to dividend holders to the beginnings of buildings your owns dividend stock portfolio. It is a one-stop place for new investors to get a great education. Discover everything you need to know about dividends and dividend investing.
A Final Word
Dividend investing is by far one of the best ways to use the stock market to generate passive income and to increase cash flow in your investment portfolio.
Remember that not every dividend-paying stock is useful for this purpose, and you must learn to identify the profitable ones in order to continue to build your wealth.
Before you purchase any investment, you should take the time to become familiar with exactly how it works, and its inherent risks and possible disadvantages. Or seek advice from a financial advisor for more info on that read: When to Hire a Financial Advisor.
If you learn as much as you can about the dividend investing approach before you buy your first stock, you will greatly increase your chances of benefiting from regular, long-term passive income, with as little risk as possible.