Many investors like to share stories of how they got into some hot momentum stock early or the frustration of how they could have but didn't. Yet far fewer share tales of increasing their portfolio slowly but surely through the humbler means of dividend compounding over decades. Dividend stocks lack the wow factor of buying in early on Google or Nvidia, but reinvesting these payouts has been among the most reliable ways to produce long-term gains. While you might not regale friends at the next BBQ or dinner party with how you reinvest your neat little dividends each year, by tuning out the hype, you might find that investing with dividend returns can deliver the strongest portfolio income over time.
Below, we take you through what dividends are, which measures are used to differentiate them, and then both the pros and cons of dividend investing strategies. Our guide will equip you to decide whether dividend-focused investing is right for you.
Key Takeaways
- Whether dividend-focused investing is right for you depends on your risk tolerance, financial horizon, and return requirements.
- Dividends are a fraction of a company's profits that its board of directors distributes to its current shareholders.
- A dividend is typically a cash payout for investors made quarterly but sometimes annually.
- Stocks and mutual funds that distribute dividends are generally on sound financial ground, but not always.
- Stocks that pay dividends typically provide stability to a portfolio but may not outperform high-quality growth stocks.
Dividend Basics
Many beginning investors do not understand what a dividend is, particularly for an individual stock or mutual fund. So, let's get that out of the way: a dividend is a payment of apart of a company's profit to eligible stockholders,typically from a publicly traded company. Not all companies pay a dividend. Usually, the board of directors determines if a dividend is desirable for their particular company based on various financial and economic factors. Dividends are commonly paid as cash distributions to shareholders monthly, quarterly, or yearly.
Shareholders of any given stock must meet specific requirements before receiving a dividend payout. You must be a "shareholder of record" on or after a date designated by the company's board of directors to qualify for the dividend payout. When you see stocks referred to as trading "ex-dividend,"this simply means that if you buy them that day, you won't be eligible for a dividend until the next dividend period.
U.S. companies pay stock dividends out of their after-tax profits. When you receive them as a shareholder, the Internal Revenue Service treats them as ordinary income, which is taxed as such.
Now that you have a basic definition of what a dividend is and how it's distributed, let's get into more detail on what you need to understand before making an investment decision.
What Is the Dividend Yield?
It may be counterintuitive, but dividend yield decreases as a stock's price increases. The dividend yield is a ratio of how muchyou get paid out for each dollar invested in a stock.Let's look at how dividend yield is calculated so we can grasp this inverse relationship.
Dividends are generally paid on a per-share basis. If you own 100 shares of the ABC Corporation, the 100 shares are the basis for your dividend distribution. Assume you bought ABC Corporation at $100 per share for a total investment of $10,000. Profits at the ABC Corporation were unusually high, so the board of directors agrees to pay its shareholders $10 per share annually in the form of a cash dividend. So, as an owner of ABC Corporation for a year, your continued investment in ABC Corp results in $1,000of dividends.
The dividend yield formula is as follows: Dividend Yield = Dividend/Price × 100
Thus, the dividend yield is the total dividend amount ($1,000) divided by the cost of the stock ($10,000), which is 10%.
If you bought ABC Corporation at $200 per share instead, the yield would drop to 5% since 100 shares now cost $20,000 (or your original $10,000 only gets you 50 shares instead of 100). As such, if the stock price moves higher, the dividend yield drops, and vice versa.
Dividend yields often come down to growth expectations. Stocks predicted to deliver faster earnings and dividend growth tend to have lower dividend yields. This is because investors bid up prices on shares with this potential, diminishing the current yields. Meanwhile, stocks with a slower growth outlook typically languish with higher yields to compensate for the limited upside.
Still, projected dividend growth alone doesn't dictate yields. Companies whose stock lightly trades (it has low volume) typically have higher yields to lure in potential buyers. Stability is also important: Firms that reliably provide dividends year after year may not necessarily see perpetually rising yields if share prices go up.
Dividends are a part of a company's profits paid to eligible stockholders monthly, quarterly, or yearly. Generally, a company's ability to pay dividends indicates good corporate health.
Assessing Dividend-Paying Stocks
Now, we can discuss whether dividend-paying stocks are a good overall investment. Dividends are derived from a company's profits, so it is fair to assume that, in most cases, dividends are generally a sign of financial health.
From an investment perspective, buying established companies with a history of good dividends adds stability to a portfolio. If held for a year, your $10,000 investment in ABC Corporation would be worth $11,000, assuming the stock price after one year is unchanged. In addition, if ABC Corporation is trading at $90 per share a year after you bought it for $100 a share, your total investment after receiving dividends would still break even ($9,000 stock value + $1,000 in dividends).
This is the appeal ofbuying stocks with dividends: they help cushion declines in the stock prices if that happens and are also an opportunity for stock price appreciation. This is why many investing legends such as John Bogle and Benjamin Grahamadvocatebuying stocks that paydividends as crucial for calculating an asset's total "investment" return.
The average dividend yield onS&P 500 indexcompanies that pay a dividend historically fluctuates somewhere between 2%and 5%, depending on market conditions. In general, it pays to do your homework on stocks yielding more than 8% to find out what is truly going on with the company. Doing this due diligence will help you decipher those companies that are truly in financial shambles from those that are temporarily out of favor and, therefore, present a good investment value proposition.
Let's review some figures you'll want to review for dividend stocks that interest you. No calculator needed: These are typically provided for individual stocks by your broker's platform or financial sites like Investopedia.
The Dividend Payout Ratio
This is the dividends as a percentage of earnings. The dividend payout ratio is calculated by dividing the dividend amount by net income for the same period.
What ratio is good? There’s no ideal percentage. The payout ratio goes from 0% for companies that do not pay dividends to 100% and beyond for companies that pay out their entire net income (or more if over 100%) as dividends. A healthy ratio depends on the profile of the company. Some companies have higher expenses than others, which affects their ratio. Also, dividend payouts are best compared within industries, not across very different sectors. Another warning is that looking at one year of dividend payments won’t give you the story of a company’s dividends over time. It’s best to look at a few years together to see if there’s an overall trend.
Generally speaking, high payout ratios are considered risky. If earnings fall, the dividend is more likely to get cut, resulting in the share price falling, too. Lower ratios, meanwhile, could suggest the potential for the dividends to increase in the future, or they could mean that the stock has low yields.
Dividend Coverage Ratio
This compares earnings or cash flows to dividends, gauging a firm’s ability to support its payouts. Higher ratios indicate more ability to cover its dividends. The dividend coverage ratio is calculated by dividing net income by the declared dividend or earnings per share by the dividend per share.
Again, a decent value depends on the company, its expenses, and its sector. Obviously, the higher the dividend cover, the safer the dividend should be. Investors generally like to see a dividend cover of at least two.
Dividend Growth Rate
The dividend growth rate tells us how much a company’s dividend has grown annually over a period of time. Higher rates may catch the attention of investors but aren’t necessarily a good thing. It could imply a company started from a low base and is making unsustainable, rapid increases.
When dividend investing, reliability trumps big, unsustainable-looking payments. Companies with a steady track record of gradually increasing their dividend above inflation are what income investors yearn for.
The Risks to Dividends
During the financial meltdown in 2008-2009, almost all major banks either slashed or eliminated their dividend payouts. These companies were known for consistently stable dividend payouts each quarter for over a hundred years in some cases. Despite their storied histories, they cut their dividends. In other words, dividends are not guaranteed and are subject to macroeconomic and company-specific risks.
Another downside to dividend-paying stocks is that companies that pay dividends are not usually high-growth leaders. There are someexceptions, but high-growth companies typically do not pay sizable amounts of dividends to their shareholders even if they have significantly outperformed the vast majority of stocks over time.
Growth companies spend more on research and development, capital expansion, retaining talented employees, and mergers and acquisitions. All earnings are retained for these companies and reinvested back into the company instead of being used to issue a dividend to shareholders.
It's also important to be aware of companies with extraordinarily high yields. If a company's stock price declines, its yield goes up. Many rookie investors get teased into buying a stock based on a potentially juicy dividend.
Advantages and Disadvantages of Dividend Investing
Pros and Cons of Dividend Investing
Pros
Another way to make money from stocks
Income stocks are generally quality businesses with predictable earnings
Reinvesting income can really boost returns
Cons
Dividends equal money not reinvested to grow business
Less risk means less potential upside
Potential for an increased tax burden
Investing in stocks that pay a dividend has pros and cons.Yes, there are a lot of advantages. However, there’s also a price to pay for those benefits.
The most obvious advantage of dividend investing is that it gives investors extra income to use as they wish. This income can boost returns by being reinvested or withdrawn and used immediately.
Dividends can also be a sign of quality. Companies that have paid dividends for a long time are generally stocks that help investors sleep easier at night. They generate a lot of cash and have predictable earnings that don’t fluctuate much.
Volatility is something else to watch. The share prices of top-income stocks generally don’t plummet. But they don’t rise much, either.
Other drawbacks of dividend investing are potential extra tax burdens, especially for investors who live off the income. Once a company starts paying a dividend, investors become accustomed to it and expect it to grow. If that doesn’t happen or it is cut, the share price will likely fall.
There’s also, of course, the opportunity cost: by investing in dividend-paying stocks, you’re not investing elsewhere. Putting your money into dividend stocks means prioritizing stable returns over those with more upside potential. Stocks with high growth potential tend to invest all their earnings back into the business. Those companies have the biggest chance of rising in value.
How Do Dividend-Paying Stocks Compare to Bonds as Investment Options?
Dividend-paying stocks and bonds provide investors with income, but they have different risk and return profiles. Bonds are generally considered safer investments, offering fixed interest payments and returning the principal amount at maturity. However, they typically offer lower returns than stocks. Dividend-paying stocks have the potential for income through dividends and capital appreciation, but they come with higher volatility and market risk. The choice between the two depends on your risk tolerance, investment goals, and time horizon. While bonds can provide more predictable income and stability, dividend-paying stocks can offer growth potential and higher income over the long term.
What Are the Tax Implications of Dividend-Paying Stocks?
The answer is initially unsatisfying: it depends. The tax implications depend on your tax situation, but generally, dividends are taxed as ordinary income at your marginal tax rate. However, qualified dividends, which are typically paid by U.S. corporations and meet certain holding period requirements, are taxed at lower long-term capital gains rates.
In addition, dividends received in tax-advantaged accounts, such as individual retirement accounts or 401(k)s, are not taxed until withdrawals are made.
Does the S&P 500 Pay Dividends?
The S&P 500 tracks thelargest companies in the U.S., many of which pay dividends. If you were to invest in an ETF tracking the S&P 500, you’d be invested in these companies and, therefore, qualify for their dividends.
The Bottom Line
Dividend-paying stocks offer several benefits to investors. First, they provide a regular income stream, which can be especially attractive to income-focused investors such as retirees. Second, dividends are often seen as a sign of a company's financial health and stability, as they indicate that it's generating enough profits to distribute at least some to shareholders. Reinvesting your dividends can lead to compounding returns over time, enhancing long-term investment growth. Finally, dividend-paying stocks can offer some protection in volatile or declining markets, as the dividend yield can provide a cushion against falling stock prices. Whether and how much to focus on dividend-paying stocks depends on your investment horizon, comfortability with risk, and other financial needs.
