Dividend investing can be an excellent way to generate income, and grow your investment portfolio over long periods of time. By focusing on solid companies that increase their dividends regularly, a small sum of money could turn into a large nest egg, thanks to the power of compounded gains. Here's a rundown of what you should know before you get started with dividend investing.
Why invest in dividend stocks?
In a nutshell, the best reason to invest in dividend stocks is to get rich slowly. Dividend-paying companies tend to be more mature and stable than their non-dividend counterparts, so while they aren't likely to skyrocket immediately, a solid portfolio of dividend stocks can create massive amounts of wealth over long periods of time.
Image Source: Getty Images.
Why don't all stocks pay dividends?
Generally speaking, newer and fast-growing companies don't pay dividends. The reason is simple -- many companies feel that the best use of their profits is to reinvest in the business and fuel further growth.
On the other hand, once companies have matured to the point where they don't need to spend all of the money they generate on growing the business, there are two main ways to return capital to shareholders -- dividends or share buybacks. There's some debate among investors regarding which is better, and many dividend stocks employ a combination of the two.
Since dividend stocks tend to be mature and profitable companies, they generally survive recessions and crashes better than non-dividend stocks, and also tend to be less volatile.
Don't just focus on yield
It may surprise you to hear that of all the metrics key dividend investors should know, which we'll get to shortly, dividend yield may actually be one of the least important. Of course, with all other factors being equal, a higher dividend yield is certainly preferable, but as long as a stock pays a reasonably strong yield (say, 2% or higher), there are several other factors you should place a higher level of emphasis on.
For example, dividend consistency and growth are two things that are significantly more important for long-term investors than the stock's current yield. Johnson & Johnson's 2.6% dividend yield isn't exactly the highest you'll find, but consider that the company is not only a remarkably consistent dividend payer but has increased its dividend for 54 consecutive years.
We'll get more into the best metrics to evaluate dividend stocks later in this guide, but for now, know that dividend yield should not be the primary focus when researching dividend stocks.
When do dividends get paid? Here are the important dates to know
Let's say that you buy a stock on September 1, and you notice that the stock has a $1.00 per share dividend payment scheduled for September 3. However, the dividend payment day comes and goes, and no additional money shows up in your brokerage account. What happened?
As a dividend investor, there are several important dates you need to be aware of, especially when you're actively buying dividend-paying stocks. Specifically, here are the dates that can help you determine if and when you'll receive a stock's next dividend payment.
- Trade date – This refers to the date you buy the stock. You may not realize it, but you technically don't take ownership of stock immediately.
- Settlement date – For stocks, the settlement date is three business days after the trade date, so a trade that took place on Monday would settle on Thursday. This represents the day that the purchase becomes finalized and you become a "shareholder of record" on the company's books. Think of the settlement date like the closing date of a real estate transaction.
- Ex-dividend date – This is the first day a stock trades without its dividend. If you buy shares before the ex-dividend date, you are entitled to that dividend payment. If you purchase the shares on or after this date, you won't get paid until the next dividend cycle.
- Record date – This date occurs two business days after the ex-dividend date, and is the date the company determines who gets a dividend and who doesn't. This ensures that everyone who completed a trade before the ex-dividend date becomes a shareholder of record on or before the record date.
- Pay date – This is the date when the dividend is paid to shareholders.
To illustrate this, consider this real-world example:
Bank of America recently declared a dividend of $0.12 per share, with an ex-dividend date of August 30. The record date for the dividend is September 1, and the pay date is not until September 29. In other words, in order to receive this dividend, investors need to buy shares on or before August 29, before the ex-dividend date.
Metrics that all dividend investors should know
We already mentioned that the dividend yield isn't the best metric to use when evaluating dividend stocks. So, here are some good ones to know.
- Payout ratio – This is the stock's dividend as a percentage of its earnings, and shows a stock's ability to continue to pay its dividend, even if profits drop.
- Total return – The combination of dividends and share price appreciation. This is the overall picture of a dividend stock's performance. For example, if a stock rises by 6% this year and pays a 3% dividend yield, its total return is 9%.
- EPS growth – Consistently growing earnings are a good indicator that a stock will be able to continue to grow its dividend.
- P/E ratio – Perhaps the most-used valuation metric, P/E ratios are typically used for evaluating mature companies, so it is certainly important for comparing dividend stocks.
One thing you need to do with all of your dividend stocks
If you're investing for the long run, it's important to reinvest your dividends to maximize your returns. You can do this by enrolling in your broker's dividend reinvestment plan, or DRIP, which will automatically use the dividends you receive to purchase additional shares.
There are several benefits to DRIP investing, such as the ability to buy fractional shares, and those DRIP transactions are commission-free. Reinvesting your dividends through a DRIP can help you build serious wealth over long time periods, so it's a must-do for long-term dividend investors.
Know the tax implications of dividend investing
Most dividend stocks pay "qualified" dividends, which receive special tax treatment. Depending on your tax bracket, qualified dividends are taxed at a rate of 0% to 20%, significantly lower than the ordinary income tax rates of 10% to 39.6%. In addition, high-earners pay a 3.8% tax on certain investment income, on top of their applicable tax rate.
While most dividends qualify for the lower rates, some dividends are classified as "ordinary" dividends and are taxed as ordinary income. Real estate investment trusts, or REITs, are a good example of stocks whose dividends are generally considered ordinary income.
Of course, this doesn't apply if your dividend stocks are held in a tax-advantaged retirement account such as an IRA.
You don't have to buy individual stocks to be a smart dividend investor
As a final thought, if you're new to investing, the best way to get started in dividend investing could be with an ETF that specializes in dividend stocks. As one example, the Vanguard High Dividend Yield ETF invests in an index of stocks with above-average dividend yields and charges investors an extremely low 0.09% expense ratio.
This is just one example, but the point is that if you'd like to get started with dividend investing, but feel like you have more to learn before you'll be comfortable with researching and investing in individual stocks, the index-fund approach could be a smart way to get the benefits of dividend investing safely, while you're still learning the basics.
Do your homework and find the best dividend stocks
Once you feel comfortable evaluating dividend stocks, you're ready to start doing some research. Here are a few examples of solid dividend stocks from our contributors to help get you started -- in addition to the stocks themselves, the important thing to notice is the reasoning behind each recommendation.