Note, stocks mentioned in this article are for illustrative purposes only, they are not recommendations to buy or sell any security. Please talk to your preferred financial advisor before taking any investment actions.
Highlights
- Dividends represent a portion of a company’s profits paid by a company to its shareholders
- Getting paid dividends is as easy as finding a stock that pays dividends, buying, and watching the dividends come in!
- Successful dividend investing requires building a portfolio of dividend stocks with safe and growing dividends
- The true power of dividends is shown overtime with dividends reinvested
- Avoid high yield traps, and be mindful of tax considerations
What Are Dividends?
Dividends represent a distribution of capital from a company’s profits to its shareholders. Dividends are typically paid out on a quarterly basis by companies to their shareholders as a reward to shareholders for maintaining ownership in the company stock. Though dividends are typically paid in cash, companies can sometimes offer shareholders the chance to be paid in additional shares of the company in what is known as a scrip dividend. The amount and frequency are determined by the company’s board of directors on an annual basis.
It’s worth noting that though dividends are a popular method for companies to distribute corporate profits to shareholders, companies can also return capital through share buybacks where the company buys shares of its own stock from the open market. This benefits shareholders, as it reduces the number of shares outstanding thereby making any remaining shares outstanding more valuable. Additionally, buybacks are tax efficient as no tax liability is created for the company or shareholder, and buybacks are an overall more flexible tool for firms to return cash to shareholders as a buyback program can be easily reduced with minimal impact to share price while even rumors of a dividend cut or cancellation can send a stock crashing lower.
Who Pays Them and How Do You Get Dividends?
Dividends are typically paid by older, more established companies, where growth in their respective industry is relatively slow such as Coca-Cola (KO) and Procter and Gamble (PG). You can quickly determine if a company pays dividends and how much per share by looking up the company on popular websites such as Yahoo! Finance. Additionally, using Yahoo! Finance ‘Historical Data’ tab and filtering for dividends, you can easily see dividend payment history for a company of interest. As an example, this page here, shows Coca-Cola’s dividend payment history going back to 1962, and, more impressively, you can see how it’s grown significantly since then (Note: KO and PG are classified as Dividend Kings).
Once you have identified a company of interest that pays dividends (more on screening stocks in a bit), getting paid dividends is incredibly easy. Simply do the following:
- Open a brokerage account if you don’t already have one (M1 Finance, Ally Invest, Robinhood, and Schwab are all great firms to check out). If starting off and you don’t have much money to invest, ensure that the broker allows you to buy fractional shares so you can more easily deploy money to buy dividend-paying stocks.
- Login to your account, type the company ticker, and buy the desired number of shares
- Sit back and wait! Note, if you just missed the latest ex-dividend date, you might have to wait up to 3-months for your first dividend payment.
Building A Dividend Portfolio
With a solid understanding of what dividends are and the potential tax implications, the first step in constructing a dividend portfolio is to solidify your investment goals. A stock’s dividend yield can vary from low (1% to 2%) to very high (4% to 6%), and consequently you can build a portfolio with a basket of stocks with an overall low yield and high growth or an overall high yield and low/medium growth. Whatever the final portfolio yield, you have to ensure that it aligns with your larger financial and investment goals.
Generally, if you need the cash flow now to pay bills and potentially supplement your earned or retirement income, you will want to build a portfolio with an above-average yield that is stable to moderately rising. Alternatively, if you have a few years before you need the income, and can reliably reinvest your dividends, you may opt for a portfolio of stocks with lower yield but a higher dividend growth rate.
With a financial goal solidified, the final part of the process is to screen for stocks with qualities that align with your goal.
Dividend Yield
Once you decide to start building a dividend portfolio, the dividend yield will likely be one of the first stops in your research process. The dividend yield is calculated by dividing a stock’s annual dividend by its current stock price. Investors will typically use the sum of dividends paid over the last 12-months, or an annualized value of the most recent dividend payment when calculating a stock’s annual dividend.
Dividend Safety
Although dividend yield gets all the attention, dividend growth and stability are arguably more impactful to an investor’s long-term returns. Everyone likes getting a lot of dividends, however, when a dividend yield is too high (too far above its industry average, or generally anything above 6%), it could mean trouble ahead for the dividend—either a potential dividend cut or outright suspension of the dividend. Consequently, ensuring the safety of the dividend is of paramount importance as dividends are not guaranteed and can be reduced or eliminated as seen during the market distress of 2020.
- Dividend growth and history: A high-level way of assessing the safety and durability of the dividend is to simply look at the dividend history. Generally speaking a company with a long history of paying and growing its dividend is more likely to maintain and increase its dividend going forward. Conversely, a company with a dividend that shows no growth or even decreases and increases suggest similar dividend volatility going forward.
The below image from DividendMax shows Coca-Cola’s dividend amount from 2006 to 2020. You can see it has more than doubled from $0.60 per share to $1.64 per share— a 173% increase.
Though this is a good starting point, all dividend kings are royalty until they are not. We need more robust ways to assess the safety of the dividend, especially if you will be counting on the income to pay bills. Enter financial ratios (not as scary as you might think, read along) :
- Payout Ratio: Dividends are paid from a company’s earnings, as a result comparing dividends paid to net income is a good way to check the overall stability of the dividend. The payout ratio is calculated simply by dividing total dividends paid by net income. Generally, a company’s payout ratio is compared to its industry’s average, and the higher the payout ratio the more questionable the safety of the dividend.
- Net Debt to EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization): A company is legally obligated to pay its bondholders first, and for this reason, it is important to ensure that a company is not overly leveraged and can safely cover its debt obligations. Dividing a company’s total liability, minus any cash and cash equivalents by its EBITDA provides investors a powerful metric to assess a company’s overall financial health and thus their ability to maintain and grow its dividend. To relate this to your own finances, you would calculate this by adding all your current debts, subtract any cash in checking, savings, and value of any stock accounts, and then divide that figure by your pre-tax salary (this is not the exact same, but shows the overall principle behind net debt to EBITDA). In general, investors like to see low relative net debt to EBITDA when compared to industry peers.
Using the above measures, you can filter the thousands of dividend-paying stocks to find a basket of durable dividend-paying stocks that align with your investment goals. In addition to screening for dividend durability, you also want to ensure that the firm’s revenue and earnings are all moving in the right direction. And lastly, you want to ensure that your portfolio is not too concentrated in any one company or sector as that would expose your portfolio income to unnecessary risk. Read here to learn more about diversification, the only free lunch on Wall Street.
If the thought of building up your own dividend portfolio from scratch seems too daunting, but you still want to benefit from the power of dividends, there are some amazing low-cost ETFs that focus on different types of dividend investing. Two great examples to kick off your research are:
- Vanguard’s VIG ETF, which holds a basket of dividend-paying stocks where the current dividend yield is low, but the underlying companies are experiencing rapid growth and the dividend payout is expected to grow at a higher than average rate.
- iShares DVY ETF, which holds a basket of stocks with a higher current yield and more moderate dividend growth rates.
Mind the Dates
Once you’ve constructed your diversified portfolio of robust dividend-paying stocks, you’ll need to ensure you purchase your stock before the ex-dividend date! Companies need to know who to send the dividends to, and to do this they need to get a list of all current shareholders by a certain cut-off date, and this date is called the ex-dividend date. To find recent or upcoming ex-dividend dates for a company of interest, you can go to the company’s investor relation page or simply Google “XYZ ex-dividend date”. Alternatively, if you are just curious what companies have ex-dividend dates coming up, MarketBeat has an awesome calendar that shows all companies with an ex-dividend date in the upcoming week.
Quick Note On Taxes
Everyone’s tax situation is different, and I am not a tax advisor, however, there are some general tax implications you should be aware of when investing in dividend-paying stocks. At the federal level, cash dividend payments are categorized as qualified or unqualified (a.k.a. ordinary or regular) dividends.
Qualified dividends are taxed more favorably as capital gains, and thus tax liabilities are either 20%, 15%, or 0% depending on your tax bracket. There are specific IRS guidelines for a dividend payment to be categorized as qualified, and details can be found here, but in general:
- Dividends must be paid by a U.S. company or qualified foreign company
- The dividends are not of the type listed later under Dividends that are not qualified dividends.
- Hold the stock for more than 60-days during the 121-day period that begins 60 days before the ex-dividend date. It can get a bit tricky to decipher, but in general, you will want to buy the stock before the ex-dividend date, and hold the stock for at least 61 days to have dividends categorized as qualified dividends.
While qualified dividends enjoy the lower capital gains tax structure, unqualified gains are taxed as ordinary income. The final tax rate applied on unqualified dividends will be determined by your tax bracket.
The last comment regarding taxes on dividends concerns the treatment of dividends received from REITs, MLPs, and special one-time dividends, which are automatically categorized as unqualified dividends and thus do not enjoy the benefits of lower capital gains tax rates.
As a reminder, please consult with a qualified tax specialist to better understand your tax situation and the impact of any dividend payments.
Are dividends worth it?
When done properly, dividend investing can seem slow and boring, after all why buy a stock with a dividend yield of 2%-3% when some stocks are doubling seemingly every year? Well for starters, just because some stocks are doubling in a year, does not mean you can accurately and consistently identify which stocks will double in a year and which stocks will end the year in the gutter.
Dividend investing provides an alternative approach to investing, where instead of trying to identify the next hot stock, you work on identifying reliable performers that will continue to perform overtime. With dividend investing you will still benefit from share price appreciation as the business grows over time, but you’ll have the added tailwind of dividends added to your account on a regular basis. Additionally, if the portfolio of stocks is well selected, those dividends will grow over time and your yield on cost will grow as well. This combination of the consistent and growing cash flow will buffer your account during bad years, lower overall portfolio volatility, and provide you with organic cash flow to reinvest and build a cash-flowing machine—overtime.
If you are still not convinced about the power of dividends, see the chart below by Hartford Funds, which shows in blue the total returns of $10,000 invested in the S&P 500 with dividends reinvested from 1960 to 2020, while the gray line represents the same initial investment but without dividends reinvested. The blue line shows the growth of $10,000 to $3,845,730, while over the same time period, the funds invested without reinvesting dividends grew to only $627,161.
Conclusion
Hopefully, this article provided you with a good overview of what dividends are, who pays them, and, most importantly, how to start getting paid dividends! As was shown, getting paid dividends is actually incredibly easy, just find a stock that pays a dividend, and buy it in your brokerage account. The hard part is building a portfolio of stocks that pays a safe and growing dividend. Three key items were shared to help you more effectively find reliable dividends that align with your investment goals: dividend history and growth, dividend payout ratio, and net debt to EBITDA. These three items are a great starting point in identifying reliable dividends to build your dividend portfolio, after that simply buy the stock before the ex-dividend date and enjoy those dividends! As a final note, don’t forget about taxes, and, at all costs, avoid high yield dividend traps.
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