Dividend investing is a method of buying stocks that pay dividends in order to receive a regular income stream from your investments. This income is in addition to any growth in your portfolio as its stocks or other holdings gain value.
What Is Dividend Investing?
Dividends are payments a company makes to shareholders. When you own stocks that pay dividends, you are getting a share of the company's profits. This allows you to receive a stream of income on top of the growth in your portfolio's market value.
How Dividend Investing Works
Buying stocks that pay dividends can reward you over time, as long as you make smart buying choices.
Some companies may have a dividend reinvestment plan, often called "DRIP." With a DRIP, you can choose to reinvest your dividends to buy more shares, instead of taking them as cash. This can be a wise plan when your dividends are small, either because the company is growing or because you don't own much stock.
Are Dividends Safe?
When investing, try to look for dividend safety. This means how likely it is that a company will keep paying dividends at the same rate or higher.
While some companies assess and rank dividend safety, you can also do your own research to learn more. All you have to do is compare earnings to dividend payments.
If a company earns $100 million and pays out $90 million in dividends, you'll make more of a profit than you would if it only were to pay $30 million in dividends. On the other hand, if it pays out $90 million in dividends, and profits fall by 10%, it won't be able to keep paying at this same high rate.
This, in turn, lowers your income. The $30 million payout could also decrease in this case, but by a much lower percentage.
In many cases, companies that pay 60% or less of their earnings as dividends are safer bets. This is because they can be counted on for predictability.
Dividend safety is also determined by how risky or new an industry is. Even if a company has a low dividend payout ratio, your dividend payment will likely be less safe if the industry isn't stable.
Look for companies that have histories of stable income and cash flow. The more stable the money coming in to cover the dividend, the higher the payout ratio can be.
Strategies for Dividend Investing
With the high dividend yield approach, the focus is on slowly growing companies that have high cash flow. This allows them to fund large dividend payments, and it could provide you with an immediate income.
If a stock pays a $1 dividend, and you can buy shares for $20, the stock has a 5% yield. If you were to invest $1 million, you would receive $50,000 in income.
Using the high dividend growth rate, your focus is on buying stock in companies that pay low dividends but are growing quickly. This means you are buying profitable stocks at a lower rate and making a large amount of income over a five- or 10-year period.
During Walmart's growth phase, the company traded at such a high price-to-earnings ratio that the dividend yield looked quite small. But new stores were opening quickly, and the per-share dividend increased quickly as profits climbed. In this case, a buy-and-hold approach would have yielded more income as dividends added up.
Different investors may prefer one approach over the other. It all depends on whether your goal is immediate, stable income or whether you prefer long-term growth and profit.
When choosing a method, decide what level of risk you prefer. Think about how long you are willing to wait for your dividends to produce your desired level of income.
What Are the Tax Benefits?
Look for dividends that are deemed to be "qualified" in order to get some tax benefits. Most income from dividends is taxed as ordinary income. But qualified dividend stocks held for a longer length of time—often 60 days or more—are taxed at the lower capital gains tax rates.
If you buy stocks to get the dividend payment, and then you want to sell them quickly, you'll have to pay your normal tax rate on that income.
Things to Watch Out For
These traders, who will have sold the stock you held without telling you, must pay you any dividends that you missed. That's because you aren't truly holding the stock at the moment. The money comes out of their account as long as they keep their short position open. Then, you will get a payment equal to what you would have made in actual dividend income.
Since the cash is not counted as a dividend, it is treated as ordinary income. Instead of paying the lower tax rate, you'll have to pay your higher income tax rate.
- Dividend investing is a way to create a steady flow of income.
- Look for stocks with stable income and cash flow.
- Choose an approach: high dividend yield or high dividend growth.
- You can set yourself up for tax benefits.