How Dividend Investing Works
A dividend is money that a company pays regularly to its shareholders. It’s sort of like saying, “Hey, thanks for investing in us, here’s a little cash bonus.”
Some people fancy dividend investing as a form of passive income. If you invest enough money in a dividend-issuing company, you could earn some serious income every quarter. Most of us don’t have enough to invest to make it that lucrative, but theoretically, it’s possible.
“Publicly traded companies share their profits with their shareholder/owners in different ways,” says Warren A Ward, a Certified Financial Planner® at WWA Planning & Investments. “A company like Apple is generally managed toward increasing its share price hoping to provide growth in investment value.”
In other words, rather than use their profits for dividends, many companies will just reinvest that profit to grow the value of their stock. On the other hand, “an older company like Texas Instruments might be toward the end of its rapid growth phase and decide to share profits via dividends,” Ward says.
So there may be a tradeoff here. You get a dividend from the company, but it might be at the cost of that company’s growth, and thus, your stock value. Randy Kurtz, Chief Investment Officer at Betavisor, puts it this way:
“Let’s assume you only own one share of one stock, and the stock is valued at $100. Every day you check your portfolio, and every day it is worth $100. Then one day, the company pays a regularly scheduled $1 dividend. You check your portfolio, and now you have $1 in cash. But your stock is only worth $99. Your total portfolio is still worth $100. The dividend did not add to your portfolio value.”
The increasing popularity of dividend investing, Ward says, is thanks to the low interest rates we’ve had in the past 5-10 years. “Dividends have been appealing because their rate of return is as high as, often higher than, interest rates,” he explains. “If you can get 2.5 percent on a bond, or on a stock that might also appreciate in value, you might lean toward the stock.” Of course, bond interest is guaranteed, he points out, but that’s a whole other topic.
If you haven’t already picked up on it, there’s a minor controversy here. There are some advantages and disadvantages to dividend investing, and even the smartest investors don’t agree on whether or not it’s a good wealth-building, money-making strategy.
The Pros of Dividend Investing
“It’s like stepping on the gas of the compounding machine.”
There’s a case to be made for it, though, and investor Marc Lichtenfeld makes a solid one:
“For the wealth builders, if you reinvest the dividend over the years, compounding works its magic. Each year you’ll wind up with more shares as the dividends are paid. And as those dividends are raised, it’s like stepping on the gas of the compounding machine.
Then, when you need the income, you’ll have a much larger base of capital generating more income than if you had simply received the dividend as cash.”
And if you need the income in the short term, there are options for that, too. Lichtenfeld suggests “perpetual dividend raisers” for generating more income each year. He even wrote about them over at MarketWatch:
“[These are] stocks that have a track record of growing their dividend every single year. That helps beat inflation…In order to stay ahead of the erosion power of inflation, you want to own stocks whose dividends are increasing at a pace faster than inflation. A company that raises its dividend every year provides a strong platform to generate income for shareholders over the long run.”
In that same article, Lichtenfeld explains exactly how to find these stocks, too, but we’ll get to that in a bit. Other experts also argue that dividends are more dependable than a company’s value. Dr. Robert Johnson, President and CEO of The American College of Financial Services, told us:
“Investing in stocks with high dividend yields is definitely a value approach. Over the long-run, dividends are much more stable than earnings or cash flow. Most companies that pay dividends want to gradually increase those dividends over time. Companies rarely decrease a dividend payment, as that is interpreted by the market as a strong signal that the firm is having financial difficulties, which is exactly the situation with GE.”
Beating inflation, solid growth, compounding returns….these are all solid reasons for dividend investing. Despite that, there are just as many experts who argue against it.
The Cons of Dividend Investing
“You’ll be hoping for filet mignon for decades while you eat Hamburger Helper in the meantime.”
Our friend Sam Dogen of Financial Samurai says that while dividend investing can indeed be a great source of passive income in retirement, there’s the issue of capital. Dividends are probably only going to pay off when you have a lot of money, like Scrooge McDuck levels of money, to invest. He writes:
“…with dividend yields relatively low at 2-3% you need a lot of capital to generate any sort of meaningful income. Even if you have a $500,000 dividend stock portfolio yielding 3% that’s only $15,000 a year. Remember, the safest withdrawal rate in retirement does not touch principal.”
To put it simply, you’re not going to make that much money unless you have a bunch of it already invested. And that can take time. As Dogen puts it, “If you’re relatively young, say under 40 years old, investing the majority of your equity exposure in dividend yielding stocks is a suboptimal investment strategy in my humble opinion. You’ll be hoping for filet mignon for decades while you eat Hamburger Helper in the meantime.”
Plus, it can be somewhat risky to target specific types of dividend-producing stocks, so there’s a question of whether the return is even worth that risk. “If I’m going to bother taking risk in the stock markets, I’m not playing for crumbs,” he continues.
Fair enough: Who wants crumbs? There’s also that tradeoff we mentioned earlier. As Investopedia explains, “Any money that is paid out in a dividend is not reinvested in the business.” They argue that if a business gives away too much of its profits, that could be a red flag that the company doesn’t have much room to grow, which is why they’re not bothering to reinvest.
Finally, Money magazine argues that dividend stocks have simply gotten too expensive to be worthwhile. “High-yielding utility shares, for instance, have grown 70% more expensive in just this past year based on their price/earnings ratios, a common gauge of stock valuations,” they write. “This makes it less likely that dividend payers can continue to produce market-beating returns.”
It might be better, the writer argues, to look at companies that are willing to reinvest in themselves.
How Dividends Affect Your Taxes
If you’re still following along, let’s add taxes to the mix just to make things even more complicated.
The money you earn from a dividend can either be taxed as a “qualified dividend” or as ordinary income.
Qualified dividends are taxed at a lower tax rate than ordinary income (between 0% and 20%), making them a much more attractive option than unqualified dividends. Unqualified dividends are taxed at your normal income tax rate, which can be as high as 39.6%, if you’re fortunate enough to earn that much money. (That’s for 2017 at least. For 2018, the top rate will be 37%.)
So what makes a dividend qualified? First, the company issuing it has to be U.S. based or, if it’s a foreign company, it has to trade on a major U.S. exchange (like the NYSE). You also have to own shares in the company for more than 60 days of the holding period.
So if you’re in the 35% tax bracket and you have a qualified dividend, it’ll be taxed at 15%. If it’s not qualified, that means it’s taxed as ordinary income, at your 35% rate. Either way, to avoid paying those taxes now, you might want to keep dividends out of a regular taxable investment account and use a tax-advantaged account instead, like a 401(k) or IRA. Of course, that also typically means you can’t touch the money until retirement.
Otherwise, you can choose to reinvest the dividend. When a company gives you a dividend, you have the option to use that money to buy more stock in the company or reinvest. Investopedia explains how this affects your taxes:
“Some of the companies that offer investors dividends will also let them automatically use dividends to purchase more shares of the stock instead of receiving cash payments. Called dividend reinvestments, investors whose dividends are reinvested into more shares of the stock, won’t be on the hook for a tax event. That’s because stock dividends aren’t usually taxable until the stock is sold. But if the dividend is reinvested and then the investors gets a cash payout instead of stock it will create a tax event.”
It sounds obvious, but if you’re pocketing that cash, whether through the dividend or by selling your stock, you’re generally going to have to pay taxes. And the tax hit can offset some of the lucrativeness of a dividend.
How to Get Started
If you’re sold on dividend investing, take note of a few important metrics when you decide what kind of stocks to buy.
(Note: Because it would be way too much to include in one post, we’re going to assume that you already know the basics of how to get started with investing, including how to buy stocks and bonds. But if you don’t, here’s a primer.)
Dividend yield is the expected annual dividend divided by the company’s current stock price, and you can look it up for any company here. For example, the yield for General Motors is 3.47%. How does that compare to other companies? Average yield varies depending on the industry. You can see how different industries stack up here.
As a general rule, though, most dividend investors recommend a yield of about 4-6%. For example, money site Pocketsense.com suggests that “a good dividend yield will vary with interest rates and general market conditions, but typically a yield of 4 to 6 percent is considered quite good. Lower yield may not justify buying stocks for dividend income and a higher yield may indicate that the dividend is not safe and may be cut in the future.”
Yield isn’t the only metric, of course. “ Simply investing in a stock because it has a high dividend yield is problematic,” Johnson says. “As some stocks with very large dividend yields are likely to have unsustainable dividend levels.”
Growth is another key metric in deciding whether a dividend is worth it or not. Remember, Lichtenfeld and other experts recommend companies that increase their dividends every year. Use that same website, Dividend.com, to look up the dividend growth.
“One need look no further than stocks that have increased their dividends for many consecutive years to find good, safe candidates for dividend investing,” Johnson says. “Some refer to these as ‘ruler stocks’ because if you laid down a ruler on a graph of dividends over time, the ruler would point to the northeast and most of the points would be very close to the ruler. Others refer to these stocks as ‘dividend kings.’…There are 20 companies that have managed to increase dividends every year for the past 50 years and that list includes 3M, Coca-Cola, Colgate Palmolive, Genuine Parts, Hormel Foods, Johnson & Johnson, Procter & Gamble and Tootsie Roll Industries.”
Johnson suggests that dividend investors look beyond yield and start with stocks that have stood the test of time.
Dividend Payout Ratio
Pay attention to another metric called dividend payout ratio. This measures the percentage of profits a company pays yearly to its shareholders. If a company earns $10.00 per share and pays a $5.00 annual dividend, that equals a payout ratio of 50%, for example.
It seems like a higher payout ratio would be good, but a lower ratio can tell you the dividend is safe, The Motley Fool explains, because it tells you how much the company wants to reinvest its profits to grow the business. After all, whether it pays dividends or not, you still want to invest in a company that grows in value. Also, Investopedia even points out that, historically, low payout dividend stocks perform better.
Look for Dividend Funds
Picking individual stocks is tough, though. It’s also risky if you don’t know what you’re doing (and most of us don’t). It also kind of goes against the old Warren Buffett strategy of “set and forget” investing. The idea behind lazy investing is, you pick a few solid funds, or groups of investments, that have performed well over time, and sit on your portfolio for the long haul, adjusting every so often as you get closer to retirement.
You can have the best of both worlds with dividend funds. Morningstar lists a few solid ones here. Instead of “dividend yield,” look for the term “distribution rate.” From there, you can buy into the fund the same way you’d buy any other fund in your investment portfolio.
Even if you go with a fund, it’s useful to be familiar with the above key metrics. Like most investing strategies, dividends can get really complicated really fast. If you break it down, though, it’s fairly easy to get started—assuming you think it’s worth it.