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What Is Dividend Investing?

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Key Takeaways

  • Dividend investing is a method of buying stocks of companies that make regular cash payouts to shareholders as a reward for owning their stock.
  • Dividends are payments that a corporation makes to its shareholders. When you own a dividend-paying stock, you are paid a portion of the company’s profits.
  • Dividends can provide a consistent income stream from your investments in addition to any growth in your portfolio from the stocks increasing in value.

How Dividend Investing Works

Dividends are payments that a corporation makes to its shareholders. When you own stocks that pay dividends, you are getting paid a portion of the company’s profits, which can help you earn income.

Companies usually pay cash dividends quarterly, and if the company’s profits increase over the years, the dividend amount may increase too. Dividends can also be paid from the company’s retained earnings, which is a sort of savings account of accumulated profits over the years. Companies can also pay dividends in stock, meaning they give equity shares instead of cash.

Example of Dividend Investing

Suppose you invest in a company that pays a 3% dividend per share. If you own one share of the company, and the shares are worth $100, you would receive $3 in dividends. However, if you owned 200 shares, you would receive $600 in dividends. The calculation is as follows:

  • ($100 share price * 200 shares) = $20,000 * 3% or 0.03 = $600

It’s important to note that when a dividend rate is quoted, it’s typically an annual dividend rate, meaning your payout would be divided by four if it was paid out quarterly. So, in our example above, your dividend payment would be $150 per quarter ($600 ÷ 4), assuming the same share price and the number of shares.

Dividend Reinvestment Plans (DRIPs)

Buying stocks that pay dividends can reward you over time as long as you make smart buying choices. Some companies may have a dividend reinvestment plan, often called “DRIP.” With a DRIP, you can choose to reinvest your dividends to buy more shares instead of taking them as cash. This can be a wise plan when your dividends are small, either because the company is growing or because you don’t own much stock.

Are Dividends Safe?

Typically, companies that have consistently paid dividends tend to be well-established and mostly profitable over many years. When investing, try to look for dividend safety, meaning how likely a company will keep paying dividends at the same rate or higher.

While there are services that assess and rank dividend safety, you can do your own research by comparing a company’s earnings—or profit—to its dividend payments.

If a company earns $100 million and pays out $90 million in dividends to its shareholders, you’ll make more of a profit than you would if it only were to pay $30 million in dividends. On the other hand, if it pays out $90 million in dividends and the company’s profit declines by 10%, it won’t be able to keep paying the dividends at the same high rate.

Lowered dividends, in turn, lower your income. The $30 million payout could also decrease in this case, but by a much lower percentage.

Tips

In many cases, companies that pay 60% or less of their earnings as dividends are safer bets, because they can be counted on for predictability.

Dividend safety is also determined by the riskiness of the industry in which the company operates. Even if a company has a low dividend payout ratio, your dividend payment might be less safe if the industry isn’t stable.

Look for companies that have a history of stable revenue, profit, and cash flow. The more stable the money coming in to cover the dividend, the higher or more consistent the dividend payouts.

Strategies for Dividend Investing

Good dividend investors tend to focus on either a high dividend yield approach or a high dividend growth rate strategy. Both serve distinct roles in a portfolio.

With the high dividend yield approach, the focus is on slowly growing companies that have high cash flow. This allows them to fund large dividend payments, and it could provide you with an immediate income.

Note

If a stock pays a $1 dividend, and you can buy shares for $20, the stock has a 5% yield. If you were to invest $1 million, you would receive $50,000 in income after a year’s worth of dividends.

Using the high dividend growth rate, your focus is on buying stock in companies that pay low dividends but are growing quickly. This means you are buying profitable stocks at a lower rate and making a large amount of income over a five- or 10-year period.

Different investors may prefer one approach over the other. It all depends on whether your goal is immediate and stable income or whether you prefer long-term growth and profit.

When choosing a method, decide what level of risk you prefer. Think about how long you are willing to wait for your dividends to produce your desired level of income.

What Are the Tax Benefits?

Look for dividends that are deemed to be “qualified” in order to get some tax benefits. Most income from dividends is taxed as ordinary income, but qualified dividend stocks held for a longer length of time—often 60 days or more—are taxed at the lower capital gains tax rates.

If you buy stocks to get the dividend payment and then you want to sell them quickly, you’ll have to pay your normal tax rate on that income.

Things To Watch Out For

If you invest through a margin account instead of a cash account, your broker might take shares of stock you own and lend them to traders who want to short the stock.

These traders, who will have sold the stock you held without telling you, must pay you any dividends that you missed. That’s because you aren’t truly holding the stock at the moment. The money comes out of their account as long as they keep their short position open. Then, you will get a payment equal to what you would have made in actual dividend income.

Since the cash is not counted as a dividend, it is treated as ordinary income. Instead of paying the lower tax rate, you’ll have to pay your higher income tax rate.

Frequently Asked Questions (FAQs)

How do dividends make you money?

If your goal is stable income, you can invest in companies that consistently pay dividends based on their track record of profit. Dividends can help retirees supplement their retirement income. However, dividends can also provide stability to a stock portfolio containing growth stocks or companies with inconsistent profitability.

What is an example of a dividend?

Let’s say you own one share of stock in a company that pays an annual dividend of 4% per share. If the company’s shares are worth $100, you would be paid a $4 dividend. If you owned 100 shares, you’d be paid $400 and if the dividends were issued quarterly, each quarterly payout would be $100 ($400 ÷ 4 quarters). 

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