What Is Dividend Investing and How Does It Work?

A Brief Intro to Dividend Investing for Beginners

Dividend Investing Strategy
Dividend investing is about one thing: Buying shares of stock that pay large cash dividends so you have money deposited into your bank account or mailed to you regularly. Dividend investors look for stocks in strong companies with high dividend yields. Getty Images

Dividend investing is one of my favorite investing topics to discuss.  If you've read my Ultimate Guide to Dividends and Dividend Investing you've learned that a company is divided into shares of stock, and sometimes, the Board of Directors decides to divide part of the profit earned by the business among the different stockholders and mail them a check (more accurately these days, send a direct deposit to their brokerage account or other investment account such as a Roth IRA), for their cut of those earnings.

For example, if a business earned $100 million in after-tax profit, the board of directors may decide to pay out $50 million in dividends and reinvest the other $50 million into expansion, reducing debt, research, or launching a new product.

If a stock pays a $1 dividend and you can buy shares for $20 each through your stock broker, the stock is said to have a 5% dividend yield because that is the equivalent interest rate you are earning on your money [$1 dividend divided by $20 stock price = .05, or 5%]. That means that if you were to invest $1,000,000 into dividend stocks with 5% dividend yields, you would get $50,000 in the mail, or direct deposited into your savings account or checking account.

The Basics of Dividend Investing Strategies Look for Safety in the Dividend Payout

Good dividend investors tend to look for several things in their favorite dividend stocks.  

First, they want dividend safety.

 This is primarily measured by the dividend coverage ratio.  If a company earns $100 millions 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 fell by 10%, there would be no cushion left for management to use.

 As a very general rule that certainly isn't applicable in all cases but still worth knowing as a sort of first-pass check, dividend investors don't like to see more than 60% of profits paid out as dividends.  

When thinking about dividend safety, it's important not to be deluded into a false sense of comfort by a low dividend payout ratio.  As one famous investor remarked, it doesn't matter how good the numbers look if you're analyzing a single power plant in New Orleans because there is tremendous geographic risk.  A terrible, low-probability hurricane that hits just right can wipe the whole thing out.  The stability of income and cash flow, in other words, is as important.  The more stable the money coming in to cover the dividend, the higher the payout ratio can be without causing too much worry.

Good Dividend Investing Strategies Focus on Either a High Dividend Yield or a High Dividend Growth Rate Approach

Next, 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 and have their respective adherents.  The former results in large cash income now, often from slow-growing companies that have little use for the obscene amount of cash flow produced so it mostly gets sent out the door, while the latter buys companies that might be paying much lower-than-average dividends to but that are growing so quickly, five or ten years down the road, the absolute dollar amounts collected from the stake are equal to or much higher than what would have been received using the alternative high dividend yield approach.

 A perfect example from stock market history is Wal-Mart Stores, Inc.  During its expansion phase, it traded as such a high price-to-earnings ratio that the dividend yield looked a bit pathetic.  Yet, new stores were opening so rapidly, and the per share dividend amount being increased so quickly as profits climbed ever-higher, that a buy and hold position could have turned you into a dividend millionaire in time.  

Of course, in rare situations, when all the stars align and the world is falling apart, you can sometimes get both - an incredibly high current dividend yield and an almost certainly high future dividend growth rate once the economy has recovered.  When situations like this happen, though they are not without risk and, in some cases, considerable risk, they hold the potential for substantial windfalls of future passive income.

 This is the reason some asset management companies specialize in dividend investing strategies.

Intelligent Dividend Investors Structure Their Accounts So Dividend Income Is Qualified and Not Collected In a Margin Account

First, let's talk about qualified dividends.  Qualified dividends are one of those more esoteric areas of tax law most people don't care about but, all else equal, if you are investing in most accounts, you are going to want your dividend income to be "qualified".  The rules are complicated so we won't get into them but, all else equal, it's a bad idea to trade dividend stocks if you are after the dividend income.  The reason?  Dividend stocks held for a short period of time don't get the benefit of the low dividend tax rates.  The government wants to encourage people to be long-term investors so it offers significant incentives to holding your shares.  

Next, we need to talk about one of the hidden risks of investing through a margin account instead of a cash account.  If you hold dividend stocks in a margin account, it is theoretically possible your broker will take shares of stock you own and lend them to traders who want to short stock.  These traders, who will have sold the stock you held in your account without you knowing it, are responsible for making up to you any dividends that you missed since you don't, actually, hold the stock at the moment even though you think you do and your account statement shows that you do.  The money comes out of their account for 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.  When this happens, since it's not actually dividend income you received, you don't get to treat the income as qualified dividend income.  Which means instead of paying the low dividend tax rate, you have to pay your personal income tax rate which, in some cases, could be roughly double what you would have otherwise had to pay.

The solution is simple.  Don't buy stocks through margin accounts.  Not only do you avoid rehypothecation risk, but you never have to worry about a margin call.  What's not to like?  Sure, it can be a bit less convenient waiting for trade settlement to get your cash following a stock sale but who cares?  If you are cutting it that close, your money shouldn't have been invested in the stock market, anyway.  In fact, you know that I'm a strong proponent that you should never invest money you don't intend to keep parked for at least five years.  Otherwise, you're introducing a meaningful element of gambling into what could otherwise be an intelligent acquisition.

What Types of Investors Prefer Dividend Investing?

There are many different types of investors who prefer the dividend investing strategy.  For some, it is a visceral, gut-level thing.  You can see the cash that comes into your accounts and arrives in the mailbox.  As long as the checks and deposits keep getting bigger over time, all is well.  For others, it is a pragmatic concern.  If you're retired and need cash to pay your bills, all the future growth in the world doesn't do you a whole lot of good, especially if the world falls apart and equities decline.  The last thing you want to do is be forced to sell your ownership at a price you know is significantly undervalued, the dividend giving you the ability to hold on through the rough times.  

Conservative investors tend to prefer dividends because there is considerable evidence that as a class, dividend stocks do much better over time.  There are several reasons this probably happens.  On one hand, when a company sends cash out the door, it either has the money or it doesn't.  Companies that pay steady and rising dividends, as a group, have lower so-called "accruals" relative to cash flow than companies that don't pay a dividend.  As you become a more advanced investor, that will be an extremely important concept for you to understand.  There are some theories that a company establishing a dividend policy forces management to be more selective in acquisitions and capital allocation policies, leading to overall better returns.  On the other hand, it's also possible that the fact dividend stocks tend to decline less compared to non-dividend stocks during bear markets plays a role in keeping the firm's market capitalization high enough that it can tap the equity and/or debt markets during times of stress, allowing it to avoid shareholder dilution and survive to acquire weakened competitors.  All probably play a role, to varying degrees at different times, for different companies, in different sectors and industries.