What Is Dividend Investing and How Does It Work?

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Dividend investing offers a chance to create a stream of income in addition to the growth in your portfolio's market value from asset appreciation. Buying stocks that pay dividends can reward you over time as long as you take care to follow a few guidelines and make intelligent buying choices.

Seek Safety

Good dividend investors tend to look for dividend safety. This is measured primarily by the dividend coverage ratio. If a company earns $100 million and pays out $30 million in dividends, the dividend might be safer than if the company was paying out $90 million in dividends.

In the latter case, if profits fall by 10%, there would be no cushion left for management to use. As a very general rule, dividend investors don't like to see more than 60% of profits paid out as dividends.

When considering dividend safety, don't find yourself lulled into a false sense of comfort by a low dividend payout ratio. It doesn't matter how good the numbers look if you're analyzing a single business in a high-risk industry.

One bad event could wipe out the whole thing. Look for companies that have a stable income and cash flow. The more stable the money coming in to cover the dividend, the higher the payout ratio can be without causing too much worry.

Focus on High Yields

Good dividend investors tend to focus on either a high dividend yield approach or a high dividend growth rate strategy. Both serve different roles in different portfolios.

A high dividend yield strategy results in large cash income now, often from slow-growing companies that have a substantial cash flow to fund dividend payments.

Another approach is to focus on a high dividend growth rate. This requires buying stock in companies currently paying lower-than-average dividends but that are growing so quickly that within five or 10 years the absolute dollar amounts collected are equal to or higher than what would have been received using the alternative high dividend yield approach.

For example, during Walmart's expansion phase, it traded at such a high price-to-earnings ratio that the dividend yield looked quite small. However, new stores were opening so rapidly, and the per-share dividend was increasing quickly as profits climbed ever higher. A buy-and-hold position in that situation could have turned you into a dividend millionaire in time.

Dividend Yield Income Example

If a stock pays a $1 dividend and you can buy shares for $20 each through your stockbroker, the stock has a 5% dividend yield because that is the equivalent interest rate you are earning on your money. In this scenario, if you were to invest $1 million in dividend stocks with 5% dividend yields, you would receive $50,000 in dividend income.

Qualified Dividend Income and Margin Accounts

If you are investing in dividend stocks, look for dividends that are designated as "qualified." If you only trade dividend stocks, you might miss out on a tax benefit.

Qualified dividend stocks held for a longer period of time—usually 60 days or longer—get the benefit of lower dividend tax rates. If you buy dividend stocks to get the dividend payment and then want to sell them quickly, you'll have to pay your regular tax rate on the dividend income.

If you invest through a margin account instead of a cash account, it is possible your broker will take shares of stock you own and lend them to traders who want to short the stock. These traders, who will have sold the stock you held without telling you, are responsible for paying you any dividends that you missed since you don't actually hold the stock at the moment.

The money comes out of their account as long as they keep their short position open, and you get a deposit equal to what you would have received in actual dividend income. Since the cash is not actually dividend income, you can't treat it as qualified dividend income. Instead of paying the low dividend tax rate, you'll have to pay your personal income tax rate.