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.

“Historically, the total return of the S&P 500 with dividend reinvestments has significantly outperformed the index without reinvestment,” says Peter Shieh, a senior wealth advisor at U.S. Consumer Wealth Management.

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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.

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.

— Pay attention to company fundamentals.

— 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?

What Is a Dividend?

A dividend is a share of a company’s profits distributed to shareholders as either stock or cash, usually paid quarterly, like a bonus to investors. Unlike share price, which can change from day to day, once a company declares it will pay a dividend on a specified date, 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 until they’re declared, however. Unlike a bond, which must pay a contracted amount or be in default, a company’s board of directors can decide to reduce the dividend or even eliminate it at any time.

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.

“Dividend-paying stocks are a great way to meet income needs while still participating in potential capital appreciation,” says Chris Huemmer, senior investment strategist at FlexShares ETFs. “The capital appreciation component is especially important in periods of high inflation, when increasing asset values can offer a layer of protection against rising expenses.”

Since companies pay their dividends at different times, retirees can create a schedule to receive a dividend check each month of the year.

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.

“One overlooked aspect of dividend income is the tax advantage many dividend stocks have over fixed-income securities,” Huemmer says. Investors who have held their dividend stock for more than 60 days before the ex-dividend date, which is usually one business day after the date you must own shares to receive the dividend, qualify for lower capital gains taxes on their dividend income. Bond interest payments are always taxed as ordinary income.

[SEE: 7 Low-Risk Dividend Stocks to Buy for a Choppy Market.]

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.

“Remember that there are two components of the total return of equities: capital appreciation and dividend income,” Huemmer says. “The last few decades have put a greater emphasis on capital appreciation as equity markets have risen greatly, but historically that has not always been the case.”

You need only look back to the “lost decade” following the tech bubble to see how dividends can buffer a stock portfolio during hard times, he says. “This may be especially important in today’s equity markets as rising labor and material costs and continued monetary tightening can depress asset values for the next several years.”

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. “Corporations that have the financial capacity to pay their shareholders dividends often have stable businesses that may exhibit greater financial strength and discipline than non-dividend-paying stocks,” says Jacques Elmaleh, a chartered financial analyst, senior portfolio manager and director of research at The Colony Group.

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.

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. So be selective when buying dividend stocks.

How to Choose the Right Dividend Stock to Invest In

When choosing dividend stocks, many of the same metrics used to evaluate non-dividend stocks apply, Elmaleh says. “These include but are not limited to the strength of the business model, operating trends, margins, financial strength, management and future prospects for the business.”

Another key measure to look at is 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.

“High-yielding dividend stocks may provide above-average income, but the yield also indicates a higher risk that the dividends are not sustainable,” Elmaleh says.

Similarly, since dividend yield is inversely related to share price, what may look like a rising dividend yield may actually be the result of a falling share price.

Firms may bump up their dividend to compensate for poor fundamentals and share performance, says Daniel Milan, managing partner of Cornerstone Financial Services.

“We see that empirically,” Huemmer says. “While the top 25% of dividend payers in the U.S. have historically outperformed, the top 10% of that quartile lags due to the unsustainability of those high dividend yields and falling stock prices.”

For this reason, he advocates for focusing on the financial health of a company when evaluating dividend-paying stocks.

Pay Attention to Company Fundamentals

Milan points to company balance sheets, profit-and-loss statements and the level of free cash flow, calculated as the operating cash flow minus capital expenditures, as good metrics to review. Since dividends are paid from a company’s free cash flow, a company’s ability to generate free cash flow is critical to long-term dividend payments.

“You want to avoid high-paying companies with large debt on their balance sheets, or companies that are expecting to decrease the dividend payout,” Shieh says. “Both could contribute to downside risk and should serve as warning signs.”

Too much debt means more of the company’s 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.

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.

He also says to be careful of the cycles inherent in certain sectors. “For example, the energy sector until last year was out of favor and, despite paying larger dividends, had underperformed for almost a decade.”

Simlarly, real estate investment trusts, or REITs, are showing high dividends following recent rate hikes. “However, given the sensitivity of real estate to interest rates, one should be vigilant on the price movement as well the earnings revisions of that sector as well.”

[SEE: 6 Reliable Dividend Stocks Paying Out for 100 Years or More]

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 and is an indicator of the sustainability of a dividend.

“A lower payout ratio is better, and indicates that a smaller portion of earnings is paid out to shareholders,” Elmaleh says. “Dividends could be more easily maintained if earnings fall or could be increased if earnings grow.”

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.

You want to find companies with a history of dividend increases, even in tough economic periods, Milan says.

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

Dividend Funds Can Be an Easier Alternative

All of these metrics aside, 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.

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

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. 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.

Similarly, an ETF may have a rule that the companies it invests in have a long history of paying dividends.

Socially conscious investors should also be aware that many dividend funds have positions in tobacco and oil companies, Elmaleh adds.

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 (barring a default). 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.

That said, “the defensive characteristics of dividend stocks can provide a lower-volatility way to stay invested in equities during rocky stock markets,” Elmaleh says. “Investors that require income from their portfolio to live can draw on the dividends and not be forced to sell stocks at inopportune times.”

More from U.S. News

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

Update 10/13/22: This article was published on a previous date and has been updated with new information.

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