Similar to how rental income plays a pivotal role in the decision-making of property investors, dividends frequently serve as a significant factor in the choices made by investors.
Delving into dividend investing unveils a world of opportunities to create passive income from your stock portfolio. By investing in stocks that provide consistent and rising dividends or considering dividend stock funds, you create a pathway for steady earnings to effortlessly add to your income.
As time passes, the effect of compounding works its wonders on your assortment of dividend-paying stocks, resulting in even better growth of your savings over the long term. So, let’s dive right in to better understand how to best start with dividend investing.
What is a dividend?
Investing money in the stock market enables you to generate income in two different ways: you can profit from capital gains when selling your shares at a higher price than your purchase price, and/or you can make money when collecting periodic dividends.
Dividend definition
A dividend is a segment of a company's earnings that it usually regularly allocated to its shareholders through monetary payments. This allocation underscores the company's choice to distribute profits to investors, delivering a concrete return on their stock investments.
However, dividend disbursements are neither mandatory nor predetermined, as it is at the company’s discretion to decide whether to issue dividends. The precise dividend amount and the payment date are contingent on the company's determinations, subject to validation through shareholder votes during the Annual General Meeting (AGM).
Types of dividends
The most well-known types of dividends are cash dividends and stock dividends.
The prevalent type among dividends is cash dividends, which entail distributing a segment of a company's earnings to shareholders through cash payments. However, some companies opt to provide additional shares of existing stock as a form of dividend instead of disbursing cash, resulting in an augmentation of the shares held by each shareholder.
Of course, there are other types of dividends offering different types of benefits, but they are less commonly used.
You may be familiar with the term "preferred dividends," which pertains to the cash dividends allocated to preferred shareholders. These dividends are typically granted at higher rates compared to those offered to common shareholders. In addition, preferred stocks provide more advantageous rights than common stock in situations involving liquidation. However, they often come with restricted or no voting rights.
You may also be acquainted with the concept of a "Scrip dividend," which involves companies providing shareholders with the opportunity to enhance their holdings without cost by obtaining newly issued shares in place of cash. The intention behind this is to automatically reinvest the dividends, thereby obtaining additional shares. That’s why this type of dividend is also often known as dividend reinvestment plans (DRIPs).
What can impact the dividend value?
Various elements can influence the value of dividends a company intends to distribute to its shareholders. These factors encompass both internal dynamics within the company and external circumstances beyond its control (as we’ve experienced during the COVID-19 pandemic):
- dividend policy of the company,
- previous dividends,
- after tax earnings,
- expected future earnings from the company,
- overall earning performance’s growth,
- availability of cash,
- debt levels,
- investment opportunities of the company and growth plans,
- shareholders expectation,
- liquidity,
- industry norms,
- industry trends,
- market conditions,
- and the economic landscape.
Pros of dividend investing
If you’re still wondering why you should invest in dividend stocks, here are 4 reasons why you should consider dividend investing:
- It is a rather low risk investment strategy, as dividend investing has a longer investment horizon that is less liable to market volatility and short-term turbulence.
- Dividends play a role in generating passive income by providing a reliable flow of earnings that doesn't demand active participation or continuous engagement. This approach stands in contrast to depending solely on selling stocks for capital appreciation. Dividend investors experience regular payouts from the companies they've invested in, making it an excellent avenue for acquiring passive income.
- By reinvesting the dividends, you can capitalize on the power of compound interest to accelerate the growth of your savings over time.
- It is often considered a good way to hedge against inflation and to get ready for retirement.
Risks of dividend investing
Of course, like any type of investment strategy, dividend investing isn’t without risk or downsides.
As demonstrated during the COVID-19 pandemic, companies can reduce or suspend dividends, often due to financial hardships or shifts in their business circumstances. Regardless of the cause, such actions can result in a reduction of your anticipated income. Furthermore, if the growth of dividends fails to match the pace of inflation, the purchasing power of your dividend earnings could erode over time.
It's crucial to recognize that dividend-paying stocks are not immune to market fluctuations. In situations where their stock prices undergo significant declines, the potential advantages of dividends may not sufficiently offset the capital loss you might incur.
Investing in dividend-paying stocks involves the consideration that the funds committed might miss out on other prospects carrying greater potential for growth. This effect becomes particularly pronounced when interest rates rise, as the appeal of dividend-paying stocks could diminish compared to fixed-income investments.
4 ways to receive dividends
There are different financial products and investment vehicles you can use to profit from dividend investing:
- investing in stocks of companies that distribute dividends (most common way),
- buying shares of dividend ETFs, which usually gather high-dividend stocks,
- engaging in share CFD trading grants you eligibility for a payment matching the dividend amount, provided you hold a positive position prior to the ex-dividend date,
- or using specific indices for dividends, such as the Dividend Aristocrats Index.
What is the dividend payment process?
Here's a simple explanation of the dividend payment procedure:
- Step 1: Company's decision to pay dividends and how much to distribute.
- Step 2: Declaration or announcement date explaining the dividend amount per share and the record date.
- Step 3: Record date analyzing which shareholders are eligible to receive the dividend payment.
- Step 4: Ex-dividend date or ex-date (usually one or two business days before the record date) being the date on which the dividend eligibility expires.
- Step 5: Payment date being the date when a company distributes the dividends to eligible shareholders.
It’s important to understand the relation between a company’s record date and ex-dividend before deciding to get into dividend stocks.
The record date, established by the company, identifies eligible shareholders to receive dividends based on their shareholder status. Only those recorded as shareholders on this date qualify for dividend payments. Investors who acquire stock on or after the ex-dividend date won't be included in the record list, and consequently, won't receive the dividend. Thus, purchasing shares on or after the ex-dividend date disqualifies you from receiving the dividend.
How to identify good dividend-paying companies
Recognizing promising dividend-paying companies requires in-depth examination and analysis to ensure the longevity and eventual expansion of dividend returns. This involves delving into crucial dividend indicators, verifying their ability to maintain long-term profitability, assessing robust cash reserves, considering modest earnings forecasts, monitoring low debt levels, and staying attuned to prevailing sector trends.
Here are a few key dividend metrics you should consider to spot the best dividend stocks:
- Dividend yield: The annual dividend payment as a percentage of the stock price, especially compared to the industry average.
- Payout ratio: The portion of earnings used for dividends.
- Dividend history and growth rate: Historical rate at which a company has increased its dividends.
- Dividend coverage ratio: Assessment of the company's ability to cover its dividend payments from its earnings.
- Free cash flow payout ratio: Contrasts the dividends distributed to shareholders with the company's available free cash flow, which is the cash remaining after accounting for operational costs and capital investments.
- Dividend Per Share (DPS) growth: It measures the increase in dividend payments on a per-share basis over time to help investors understand how much more dividend income they can expect per share each year.
Exploring "Dividend Aristocrats" and "Dividend Champions" could also be helpful.
These categories encompass companies with solid records of steadily raising their dividend payouts over time. Dividend Aristocrats comprise S&P 500 members with at least 25 years of consecutive dividend increases. Dividend Champions encompass similar companies, but the term is often used more broadly, encompassing businesses from diverse indices beyond just the S&P 500.
Best dividend stocks according to Morningstar as of August 2023
- Verizon Communications (VZ)
- Pfizer (PFE)
- Comcast (CMCSA)
- Wells Fargo (WFC)
- Medtronic (MDT)
- Gilead Sciences (GILD)
- Dow (DOW)
- WEC Energy (WEC)
- DTE Energy (DTE)
- PPL Corp (PPL)
Best tips to build a strong dividend portfolio
Before embarking on your investment journey, define your investment objectives. Are you seeking long-term growth, consistent income, or a blend of both? Your objectives will shape your investment strategy – whether you opt for high-yield, dividend growth, dividend aristocrats, dividend champions, or dividend reinvestment plans. You must also assess your current financial standing and risk tolerance.
Once your investment plan is in place, take the opportunity to assess and choose a reputable brokerage platform that aligns with your trading requirements.
Subsequently, pinpoint dividend-paying firms in harmony with your investment goals and risk tolerance. Seek out companies boasting a history of unwavering dividend distributions, robust financials, and a competitive edge within their sector.
Examine the industry and sector where these firms operate. Grasp the present trends, hurdles, and growth potentials that could impact their dividend sustainability.
Additionally, remember the significance of diversification – avoiding concentrating all your funds in one stock. By diversifying across various sectors and industries, you can mitigate risk and fortify your portfolio against potential underperformance in any one company or sector.
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