5 Facts You Didn't Know About Dividends

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Dividend investing can be a great way to build wealth over time, but there are some aspects of dividend investing that are not well-understood by many investors. With that in mind, here are five facts about dividends and dividend stocks you may be surprised to know.

Dividends have been around for hundreds of years
Dividends are as old as the stock market itself, and many companies have paid dividends consistently for centuries -- particularly banks and utilities. My Foolish colleague John Maxfield recently wrote an article about nine publicly traded companies that can trace their dividend histories back to the 1860s or earlier. The longest-running dividend payer on the list was Bank of New York Mellon, which has been paying dividends since 1785, the year Napoleon became a lieutenant in the French artillery.

Dividend income is taxed differently
Before you buy your first dividend stock, you should know about the tax implications. Dividend income is taxed if your stocks are held outside of a tax-advantaged retirement account, but most dividends are taxed at a lower rate than ordinary income.

As long as the dividends you receive meet the definition of "qualified" dividends -- from U.S. corporations and foreign corporations trading on major U.S. exchanges, and you held the stock for more than 60 days during the 120-day period around the ex-dividend date -- they will be taxed at more favorable rates.

A high dividend yield is not the best metric to look at
When evaluating a dividend stock, you need to look beyond the dividend yield itself. Just because a stock pays a high dividend does not make it a superior investment -- there are several other factors to look at, and one of the most important is the payout ratio.

The first thing you should ask when you see a high dividend is how sustainable it is. In other words, if a company's profits fell significantly, would it still be able to maintain the payout? This is known as a payout ratio and can be a good indicator not only of the ability to continue the dividend payments, but to increase them in the future.

For example, as I write this, IBM pays an annual dividend of $5.20, and is expected to earn $15.01 per share in 2016. So, IBM's forward payout ratio is 35%, leaving 65% of its earnings to buy back shares, pay down debt, and reinvest in the business. On the other hand, Chevron pays an annual dividend of $4.28 per share but is only expected to earn $3.46 in 2016, meaning that it actually will pay out more than 100% of its earnings. Now, this doesn't mean Chevron will cut its dividend. However, it does mean that the company may have to dip into its reserves just to make its dividend payments.

Dividend stocks are not necessarily low-risk
One popular myth is that dividend stocks are inherently safer than non-dividend stocks. This can be true in some cases -- for example, new companies that are focused on growth tend to be volatile, non-dividend stocks. On the other hand, many large and established companies produce fantastic returns with low volatility without paying a dividend. My favorite example of this is Berkshire Hathaway, but there are others.

Also, just because a stock pays a dividend doesn't make it safe. Investors in stocks like Citigroup, AIG, and Bank of America found this out the hard way during the financial crisis. Oil and energy investors are seeing this now -- just look at Linn Energy, a longtime favorite of many income seekers. There are many factors that contribute to a company's ability to make it through tough times unscathed, but the fact that it pays a dividend isn't one of them.

Dividend growth and reinvestment can make you rich
One of the most powerful tools available to long-term investors is consistent dividend payments that grow over time. We can illustrate this by looking at the total return of dividend stocks, which accounts for share price as well as dividend reinvestment.

As an example, consider one of my favorite dividend stocks, Realty Income, which went public in 1994 and has increased its dividend payment 83 times since. Over the years, Realty Income's share price has appreciated by a total of 562% as of this writing. In other words, a $10,000 investment in 1994 would have grown to $66,200 today -- a pretty impressive gain. However, if you had invested $10,000 and reinvested those growing dividends, your investment would be worth $280,000 today. That's the power of dividend growth.

The same principle holds true for other dividend growth stocks as well. In fact, an ABC news report from 2012 found that 90% of the S&P 500's nominal total return during the 100-year period from 1910 to 2010 could be attributed to dividends and dividend growth.