The Ultimate Guide to Dividend Stocks

Dividend stocks are a staple of every income investor’s portfolio, but don’t dismiss them as a retiree’s investment only. Dividend stocks have a role to play in any portfolio, no matter the investor’s age or financial circumstances. The reason: compounding.

When the dividends these stocks pay are reinvested, an investor’s wealth snowballs. The more dividends you reinvest, the more shares you own, and the more shares you own, the larger your future dividends will be. Dividend reinvestment accounted for more than 40% of the average annual total return of the S&P 500 since 1930, according to research by Santa Barbara Asset Management.

“Each decade has seen varying degrees of contribution, but the biggest takeaway is that dividends matter to a long-term investor,” says John Gomez, the founder of Brentview Investment Management, a boutique money manager with a singular focus on dividend growth investing.

At the same time, there’s plenty of room for dividend stock investors to go wrong, from choosing companies with unreliable dividends to fixating on the dividend yield alone. “Today’s dividend investor has to focus on the resilience of the company that is paying that discretionary dividend payment,” Gomez says.

In 2008, 120 companies eliminated their dividends, he says. In March 2020 alone, more than 90 companies suspended or eliminated their dividend.

“In just one month, the March tally amounted to three-quarters of the total 2008 financial crisis dividend cuts,” he says. While some companies reinstated their dividends by the end of 2020, the March string of dividend cuts has made him “suspicious of the higher dividend-yielding companies, as this may be a sign the dividend is unsustainable.”

It also highlights the importance of being a discerning dividend investor. What follows is a primer on dividend stocks, including:

— What is a dividend?

— The difference between preferred and special dividends.

— Why do people invest in dividend stocks?

— Why companies pay dividends.

— Why companies don’t pay dividends.

— How to choose the right dividend stock to invest in.

— Use the payout ratio to find sustainable dividends.

— Look for dividend growth.

— Beware of cyclical sectors and companies with too much debt.

— Dividend funds can be an easier alternative.

— How much to invest in dividend stocks?

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What Is a Dividend?

A dividend is a share of a company’s profits distributed to shareholders and usually paid quarterly, like a bonus to investors.

“A dividend is cash in your pocket,” says Nick Getaz, portfolio manager for the Franklin Rising Dividends Fund (ticker: FRDPX) at Franklin Templeton in New York. Unlike share price, which can change from day to day, once a company commits to paying a dividend, it’s as good as guaranteed.

Dividends are a way for shareholders to participate and share in the growth of the underlying business above and beyond the share price’s appreciation. This sharing of the wealth can come in one of two forms: cash dividends or stock dividends.

In the U.S., most dividends are cash dividends, which are cash payments made on a per-share basis to investors. For instance, if a company pays a dividend of 20 cents per share, an investor with 100 shares would receive $20 in cash. Stock dividends are a percentage increase in the number of shares owned. If an investor owns 100 shares and the company issues a 10% stock dividend, that investor will have 110 shares after the dividend.

Dividends are not guaranteed. They’re “at the discretion of the board of directors,” says Scott Davis, senior portfolio manager and head of income strategies at Boston-based Columbia Threadneedle Investments. Unlike a bond, which must pay a contracted amount or be in default, the board of directors can decide to reduce the dividend or even eliminate it at any time, he says.

The Difference Between Preferred and Special Dividends

While no dividends are guaranteed, some take precedence over others. Shareholders who hold preferred stock have a higher claim on a company’s assets than common shareholders but a lower claim than bondholders.

If a company is forced to cut its dividends, it starts from the bottom of the hierarchy and works upward. It’ll pay bondholders first, then preferred shareholders and, if there’s anything left over, give common stockholders their due.

Companies use this same hierarchy when deciding how to allocate capital in good times, too. They’ll often pay preferred shareholders first and give them a larger dividend than common shareholders.

Another type of dividend is the special dividend. Special dividends are like bonuses on top of your dividend paycheck. They’re a one-time dividend payment a company may make after a particularly good quarter or if it wants to change its financial structure. These extra dividends tend to be made in cash and are often larger than regular dividend payments.

Why Do People Invest in Dividend Stocks?

Even though dividends aren’t guaranteed, many investors rely on them as a source of income. Because companies pay their dividends at different times, retirees can create a schedule to receive a dividend check each month of the year, says Boston-based Bill McMahon, senior vice president and chief investment officer of active equity strategies at Charles Schwab Investment Management.

Meanwhile, younger investors — who may not need the income now — can put those dividends to work immediately in their portfolios by reinvesting them. Dividend reinvestment plans automate this process, but even if you reinvest your dividends, they are still taxed the year you receive them. The exceptions are dividends in a tax-advantaged account like an individual retirement account, where the money grows tax-free until it’s withdrawn.

Dividend stocks also often benefit from higher yields than bonds when interest rates are low, while simultaneously offering the potential for share price appreciation. Even if the price falls, the dividend can cushion a portfolio with steady income, and if you reinvest those dividends, a lower share price gets you more shares per dividend.

So investors can benefit from dividend payments, but what’s in it for companies?

Why Companies Pay Dividends

Because dividends are typically a sign of financial health, a company may offer them to attract investors and drive the share price up. A company that commits to paying a dividend is often a higher-quality and more stable company, says Matt Quinlan, who also manages FRDPX.

Generally, companies pay dividends when money is left over after covering operating expenses and business reinvestment. That’s why mature companies, which require less capital reinvestment, are more likely to pay a dividend.

“As a result, they’ll start to grow their annual dividend to share their profits with their shareholder base,” McMahon says.

Why Companies Don’t Pay Dividends

A young, rapidly growing company, on the other hand, often needs to reinvest all its capital to fuel growth and can’t afford to pay a dividend. Some investors prefer this because dividends are taxed at ordinary income rates. If a non-dividend-paying company reinvests its capital and grows, investors benefit from the rising stock price, a gain that isn’t taxed until they sell.

A mature company may also skip paying a dividend in favor of reinvestment or to cover costs. This can be a bad omen for investors, particularly if the company is under financial strain or anticipates future earnings to slow.

“When a company suspends or cuts its dividend, we view that as a negative signal” and will typically sell those investments, McMahon says. So be selective when buying dividend stocks.

How to Choose the Right Dividend Stock to Invest In

A common starting point for choosing these investments is the dividend yield, or the annual dividend per share divided by the share price. The yield measures how much income investors receive for each dollar invested in the stock. For example, a stock trading at $100 per share and paying a $3 dividend would have a 3% dividend yield, giving you 3 cents in income for each dollar you invest at the $100 share price.

This U.S. News online screener lets you narrow your search by yield. But the highest-yielding companies are not necessarily the best dividend stocks to buy.

Investors often think of the dividend as separate from the ups and downs of the stock market, but they’re actually more connected than people realize, Davis says. Dividend yield and share price move in opposite directions. If the share price falls — as it often does when a company is in financial trouble — the dividend yield will rise. Investors looking at the dividend yield alone could miss the big picture.

“What we really want is that combination of growth in our principal and growth in our income,” Davis says.

This is known as total return, or the increase in share price and paid dividends. To find companies that are good total return prospects, investors should consider what enables a company’s business to grow so that its dividend will, too.

[SEE: 7 Dividend Stocks to Buy and Hold Forever.]

This may sound daunting, but the process isn’t that different from asking a bank for a mortgage, he says. The same way a lender looks at your bank statements and pay stubs to determine how much cash is coming in and if you can afford to pay your mortgage, investors can read a company’s financial statements to determine how it funds the dividend and if it can afford to continue paying it.

“If a company isn’t funding (its dividend) through cash flow and operations, (it’s) either depleting assets or borrowing money to pay it, and normally that’s not sustainable,” Davis says, so the dividend may be short-lived.

Dividends are paid from a company’s free cash flow, calculated as the operating cash flow minus capital expenditures.

“Companies with a demonstrated ability to generate free cash and return that cash to shareholders over time will be in a better position to deliver superior total return however the wind blows,” says D.J. Shaughnessy, a portfolio manager at HM Payson & Co. in Portland, Maine.

“The best thing you can have as far as a strong dividend-paying stock is a healthy company,” Davis says.

A healthy company is one with stable, growing cash flow and earnings. To view a company’s quarterly and annual earnings and its free cash flow, pull up the company’s description page by searching the name or ticker on the U.S. News website and look under Company Vitals.

Use the Payout Ratio to Find Sustainable Dividends

Also available under Company Vitals is the dividend payout ratio, which calculates the proportion of the firm’s earnings paid as dividends.

The payout ratio is another indicator of the sustainability of a firm’s dividend policy. A company that pays out too much of its earnings can’t expect to sustain both its dividend and its growth.

Research by Brentview Investment Management found that the companies with the highest payouts and dividend yields not only underperformed the S&P 500 during the March 2020 sell-off, but also lagged the overall market for the calendar year. Additionally, some of these same companies ultimately cut their dividends as the year progressed.

“In today’s environment, dividend yields ranging between 1% and 3%, coupled with payout ratios in the 10% to 40% range should have a greater likelihood of not only surviving in the near term without cuts, but potentially thriving in the future with dividend growth longer term,” Gomez says.

This modest payout ratio works to an investor’s favor because the company is then able to reinvest the rest of its earnings. If that reinvestment is successful and the business grows, then the following year, when the company again pays a dividend, the dividend is larger because the earnings for the year are higher.

Look for Dividend Growth

A sustainable dividend with growth potential is like hitting the jackpot. If you get both, you can create an ever-increasing income stream from the stock, which is something bonds, with their fixed coupon rates, can’t provide.

To find companies with sustainable and growing dividends, Getaz and Quinlan apply four screens. First, the firm must have doubled its dividend over the past decade. This translates to about an average 7.2% annual dividend growth rate, Quinlan says, putting it well above the average annual inflation rate of 3.8%.

A stock with a dividend that outpaces inflation can be like a “pension with a cost-of-living adjustment,” McMahon says.

For consistent annual dividend increases, Getaz and Quinlan look for firms that have increased their dividend in eight out of the 10 prior years.

The company should also have a payout ratio below 65%. “We’re not looking for companies that are increasing their dividend by simply ratcheting up the payout ratio,” Getaz says. “It’s all about this idea of ongoing, consistent reinvestment in profitable growth opportunities that tends to be embedded in the culture and allows for a robust free cash flow over time.”

The final screen they apply is limiting a company’s long-term debt-to-capital ratio to less than 50% or only investment-grade debt. “You don’t want a company that puts its dividend at risk by overleveraging itself,” Getaz says.

[Read: 5 Undervalued Dividend Stocks to Buy.]

This gives them an advantaged starting point by narrowing their investment universe to the highest-quality dividend payers. “There’s an embedded character of resilience in a company that can demonstrate this track record,” Getaz says. These are companies that have been able to maintain their dividend — and generally increase it — throughout the business cycle.

There are times when a company may not be able to increase its dividend or may increase it at a slower rate, but overall, companies that can pass these screens will be more stable and more reliable dividend payers. This is evidenced by the fact that, in 2020, FRDPX had high-single-digit dividend growth, while the S&P 500’s dividend growth was essentially zero, Quinlan says.

“Our companies are increasing their dividend as a function and a result of sustainable investment over time,” Getaz says. “This should, if done correctly, produce a more sustainable growth profile.”

He also adds that there is a positive correlation between companies that score well on the team’s dividend metrics also tend to have higher ESG scores — which refers to environmental, social and governance issues. “There’s an intuitive rational that the kind of sustainability required for a company to maintain its dividend may be because the practices it engages in are more sustainable and thus help drive better ESG scores,” he says.

From the results of these screens, the FRDPX team then tries to identify which of the companies will continue to grow their dividend over the next decade. The best dividend growth companies are typically well positioned from a competitive standpoint, with strong financial metrics and appropriately allocated capital, Quinlan says. They are usually targeting large markets with growing customer bases in industries that are rewarded for innovation, but they often aren’t growing the fastest.

“In fact, they tend to not be the fastest-growing companies, but they have the wherewithal to keep increasing their dividend year over year,” McMahon says.

Beware of Cyclical Sectors and Companies With Too Much Debt

Avoid commodity-linked companies or those in sectors with cyclical profits and cash flow, he adds. “They may not be able to continue paying a dividend in the down cycle for that particular commodity or sector.”

You should also steer clear of companies with too much debt because that means more of their cash outflows are controlled by bondholders, whose interest payments are mandatory, rather than shareholders, whose dividends are optional. In hard times, these firms could cut their dividends to avoid defaulting on bond payments.

Of course, any company can experience a setback, and diversification is an investor’s best hedging strategy. Experts recommend diversifying dividend income across companies and market sectors.

Dividend Funds Can Be an Easier Alternative

A simpler way to get a diversified dividend strategy is to invest in mutual funds and exchange-traded funds.

Mutual funds have the benefit of active management, meaning a professional manager is actively selecting the best dividend stocks to invest in. That active management, though, will come at the cost of a higher expense ratio. Dividend ETFs are usually cheaper, as they don’t have a manager hand-picking stocks for the fund and instead simply mirror an underlying index.

One caveat for passive dividend ETFs is that they may have rules embedded in their strategy that create sector concentrations, Gomez says. If the ETF has an undue focus on chasing yield, for instance, it will often be heavily tilted toward slow-growing sectors such as utilities, consumer staples or financials.

“2021 has seen a resurgence of performance from dividend payers, especially versus non-paying companies,” Gomez says. “Year to date, the largest dividend ETFs have generally outperformed versus the S&P 500, but it really depends on their sector exposure.” For instance, ETFs weighted toward financials have done well as interest rates rose, but other typical dividend-oriented sectors like consumer staples, utilities and health care have lagged, he says.

Similarly, an ETF may have a rule that the companies it invests in have a long history of paying dividends. This could lead the fund to miss out on newer dividend stocks, such as Apple ( AAPL), which only began paying dividends in 2012. For example, if the fund requires 10 years of dividend-paying history, it still wouldn’t own Apple today, Gomez says.

How Much to Invest in Dividend Stocks?

Your risk tolerance, investing time frame and income needs will determine the portfolio percentage to allocate to a dividend strategy.

Remember, dividend stocks are not bonds, which guarantee the return of your principal. Like any stock, dividend stocks are subject to market and company-specific risks.

In addition, dividend stocks face interest rate risk. When interest rates rise, investors may flee dividend stocks for the guaranteed income of bonds, prompting dividend stock prices to fall.

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The Ultimate Guide to Dividend Stocks originally appeared on usnews.com

Update 04/20/21: This article was published on a previous date and has been updated with new information.

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