How To Invest In Dividend Stocks
In recent years, more and more people have realized that they need to be invested. Hoarding cash in a bank account is almost guaranteed to be a losing strategy. This is why people have been turning to stocks and bonds. As a matter of fact, bond yields have also barely managed to stay afloat. Many bond investments around the world are raking in a negative yield in real terms as yields have fallen and no longer adequately compensate for inflation.
In times of low bond yields, investors have been looking for alternatives that provide a steady cash-flow to replace former bond yield income. One such alternative are dividend stocks, particularly the ones with a proven track record and a long history of dividend payouts. This is why with some professional investors, such dividend paying stocks have taken the place of bonds as a portfolio’s defensive line.
What are dividend stocks & how do they work?
Dividend stocks offer an investor two wealth-building options: As every other stock, dividend stocks are also traded on the open-market and therefore may increase in value. Additionally, to a stock’s price increase, dividend stocks yield a steady cash-flow in the form of dividends. These dividends are paid out by the respective company and come from the profits the company decides to share with its shareholders. This means: Dividend payments are made to investors that own stock in the company. For each stock that is held, the owner is paid a specific amount that is determined by the company’s profits as well as their respective dividend policy. Usually, this policy is agreed upon at a company’s general meeting.
Here is a concrete example to illustrate how it works: Say you purchased 1,000 shares of a company for $5 each. Your total investment amounts to $5,000. Assuming the company pays out a $0.1 annual dividend per share, your investment earns you $100 per year.
Companies report their dividends in some form or another. The balance sheet reveals how much a company has in retained earnings. With the income statement on the other hand, net earnings can be assessed. These two figures allow us to calculate dividends by subtracting the net change in retained earnings from the annual net income.
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why do companies pay dividends?
Fact is: Although dividends are never guaranteed, many large companies pay dividends. As numbers show, 84% of the companies in the S&P 500 index currently distribute dividends to their shareholders. So, if paying dividends is not mandated, why do many enterprises still do it?
One obvious reason is to attract investors. Paying dividends can be worthwhile for a company since some people are willing to buy this company’s stock that might not do it otherwise. On net, this can have a positive effect on the stock’s price as it can also reduce a stock’s flow. Paying out dividends – especially if done consistently – also signals to the market that the company must be in good financial health. It’s a way of demonstrating one’s stability and strong position to afford regular cash flow payments.
If a company has no other way to profitably invest the money, it makes sense to pay out dividends to shareholders as they can take the money and potentially re-invest it profitably. This way a company can keep its return on equity high.
Watch the video: Why Invest in Dividend Growth Stocks?
Pro & Cons of dividend stock investing
- Dividend stocks offer a passive income stream in perpetuity if the respective company is committed and able to pay out dividends. So, the beauty of stocks that pay dividends is that they give an investor predictable payments.
- Dividends represent solid total investment returns, meaning that the returns are a combination of dividends paid as well as a stock’s value increase.
- There exist so-called dividend reinvestment plans (DRIP) that make sure dividends are reinvested for further returns. These plans are conducated as an automated strategy. There are basically three ways to have such DRIPs carried out: Directly through the company that is paying the dividends, through a broker or through a third-party transfer agent.
- Defensive, long established dividend stocks can serve as bond alternatives as they offer a steady cash flow as opposed to bond coupon payments.
- Returns on dividend stocks are subject to tax inefficiencies as they are taxed twice. Not only are corporate profits taxed, but dividend payouts are also taxes as income on the investor’s side.
- As with any stock, there is also investment and volatility risk with dividend stocks.
- Dividend stocks are at the risk of dividend policy changes. Also, if there is an economic crisis, there exists the possibility that dividend payments are temporarily suspended.
Choosing a proper dividend stock portfolio requires investment research. There are specific dividend metrics to look for. Also, choosing a dividend stock for its high yield might not be the best thing as high yields might be the result of a stock’ price falling due to a potential dividend cut. As an investor you need to make sure not to fall prey to what is called the dividend yield trap.
Popular dividend paying stocks
A good approach for finding popular dividend paying stocks is looking at so-called dividend kings or dividend aristocrats. These terms define a sort of category of firms that can boast of having a long-term dividend payout history. Dividend aristocrats include firms that have been offering dividends for 25 years non-stop. Firms that have been paying dividends for more than 50 years in a row are among the dividend kings, which are as follows:
- American States Water is a water and electricity utility company that has been paying dividends for 67 consecutive years. Currently the dividend yield stands at 1.61%.
- Procter & Gamble (PG) is a multinational consumer goods corporation with a track record of paying dividends for 66 years. The current dividend yield is 2.57%.
- Dover Corp. is a conglomerate manufacturer of industrial products that has also been paying dividends for 66 years. At the moment the dividend yield is 1.3%.
- 3M is a corporation operating in the fields of industry, worker safety, US health care and consumer goods. Their history shows a non-stop dividend payout schedule of 63 years. Its current dividend yield stands at 2.92%.
- Coca-Cola Co. is the best-known soft drink manufacturer and has paid dividends for 59 years without omitting once. The current dividend is 3.11%.
- AT&T is a company in the field of telecommunications. Its dividend yield is one of the highest standing at 6.49%. Also, the firm has been paying dividends for 39 straight years.
- McDonald’s is the most famous fast-food provider. It has been steadily paying dividends for 44 years. Its most recent dividend yield stands at 2.2%.
In addition to single dividend stocks, there is also the possibility to hold ETFs that consist of a portfolio of several dividend-paying stocks. A popular ETF is the ProShares S&P 500 Dividend Aristocrats ETF (NOBL). It holds only S&P 500 stocks that have paid dividends for at least 25 consecutive years.
How are dividends taxed?
As with most assets, cash flows from dividend stocks are taxed differently from jurisdiction to jurisdiction. As a matter of fact, though, virtually everywhere dividends are taxable, but the exact tax rate depends on whether a dividend is considered qualified or nonqualified.
In the US, qualified dividends are taxed at a rate of 0% to 20%. While nonqualified dividends, those paid by real estate investment trusts (REITs) for example, are taxed at the ordinary income tax rate of 10% to 37% or more.
How to invest in dividend stocks
Step 1: Find dividend paying company
First, a dividend paying company needs to be found that is stable and has good financials. As such a company’s track record and history regarding its dividend payments need to be studied. The better the track record and the more steadily a company’s dividend payments have been, the more likely it is that they will continue into the future.
The company’s financial statements need to be examined in order to evaluate whether the company is in a good position to remain financially solvent. This also means that the company’s debt holdings need to be evaluated. Too much debt can force a company to use some of its profits to pay down the debt, which means that dividends would have to be cut.
When it comes to dividend yields it makes sense to not only focus on how high the dividend yield is but also how steady those dividend payouts have been and whether the company has managed to increase its dividends over the years.
Step 2: Open a brokerage account
Although dividend paying stocks can be acquired from the stock issuing company directly, this only works for certain people and under certain circumstances. The most popular way to invest in dividend stocks is through a broker. To use one of these, you have to open up a brokerage account.
A broker typically has access to a wide variety of dividend stocks. Most brokers allow you to operate a portfolio under your name. They are compensated through trading fees, commissions, and other means, which is why an investor always has to make sure he understands the fee structure involved with buying dividend stocks. Popular brokers with low or no fees are Fidelity, Robinhood and Schwabb. They have simple user interfaces and provide access to the most common financial instruments such as dividend stocks.
Step 3: Define your investing strategy
Once a stockbroker has been chosen and an account has been set up, you have to properly define your investing strategy. The following points need to be considered:
- Do I want to reinvest stock dividends in order to profit from the power of compound interest? If so, a dividend reinvestment plan has to be chosen.
- How to best diversify? Will I only buy a few defensive dividend stocks? Will I buy other stocks and financial instruments in addition to the dividend stocks? Will I diversify using a dividend stock ETF that also diversifies across different industries?
- If dividends are not automatically reinvested, how can I best save the cash earned? Leaving it in my bank account might not make sense in the age of asset price inflation. Will I buy other assets besides stocks?
- Will I neither invest nor save the cash but spend it? In that case, the dividend I earn can be seen as a passive income, a salary of some sort that I can use to pay daily expenses like rent, food or other things.
Dividend stocks combine the best of two worlds. As they are stocks, they can offer an investor a price increase. At the same time though, dividend stocks provide a steady cash flow, making a passive income possible. Today, dividend stocks that have a long track record of stable dividend payouts, while their company has a stable business model going forward, can be seen as a good diversifier vis-a-vis bonds that have almost no yield anymore.