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Updated on Wednesday, December 19, 2018
There are many good reasons to invest in stocks. While many people buy them to profit from an increase in the price of shares, stocks that pay dividends can also be an excellent source of steady income for investors.Here, we’ll explain why dividend-paying stocks may be a good idea for your portfolio and what to look for in those stocks.
What is a dividend?
A dividend is a distribution from a portion of a company’s earnings that is paid to holders of a specified share class(es) of the company’s stock. Dividend payments are most often issued to shareholders as cash payment on a quarterly basis, but stock dividends — dividends paid as additional shares of stock — are not uncommon. Special dividends can also be issued at the time of the company’s choosing.
Dividend decisions are made by a company’s board of directors and based on a number of factors. One factor might be whether receiving the dividend payments is better for the shareholders than the returns on the stock that might be realized by reinvesting the money back in the business.
The basics of dividends
The dividend yield is the stock’s annual yield divided by its current stock price. The annual yield is the company’s latest quarterly yield times four. For example, if a stock’s price is $50 per share and its annual dividend payment is $2.50 then the current dividend yield is 5%. Even if the actual amount of the dividend payments remains unchanged, a stock’s dividend yield can go up or down based upon changes in the stock’s price.
As an example, let’s look at the price and dividend yield of Exxon Mobil’s stock (XOM):
|Date||Share Price||Annualized Dividend per Share||Dividend Yield|
The dollar dividend payout remained constant, but the percentage dividend yield increased due to the decline in the stock’s price per share.
Dividend growth is a key metric in some stock valuation models. Dividend growth pertains to the growth in the dollar level of the stock’s dividend payout. Stocks that have a consistent record of increasing their dividend payout are often considered to be strong, solid performers. The ability to continually increase their payout is a sign of financial strength for the company.
The Vanguard Dividend Appreciation ETF (VIG) only includes stocks which have increased their dividend payment for at least 10 consecutive years. There are many other mutual funds and ETFs with similar investment strategies.
Total return for stocks, ETFs and mutual funds includes both price appreciation of the shares and the dividends paid. Dividends have been a significant component of the return of the stocks in the S&P 500, comprising about 50% of the index’s total return since 1871.
Dividends are not an ‘extra’
“The average person thinks about dividends as something extra they are receiving from the company,” according to Brandon Renfro, an assistant professor of finance at East Texas Baptist University who also maintains a retirement planning practice.
He indicates that, in reality, the money paid out in dividends is the shareholder’s money, and it’s just being paid out in this fashion. This reinforces the need for investors to take a total return approach when looking at stocks.
How to invest in dividend stocks
If you’re considering making dividend stocks a part of your investing strategy, you will need to decide how you want to invest and in what types of dividend stocks you want to focus on.
- Dividend-growth stocks represent companies with a record of generally increasing the dollar amount of their dividend payout. These are often companies with solid financial track records and companies that are considered blue-chip stocks. When looking at individual stocks that fit this description, check out the dollar value of the dividend payout per share over time. There are a number of sites that carry this data and that allow you to screen for it, such as Morningstar and Yahoo Finance. You can also go to the investor section of a company’s website and research the stock’s dividend history.
- Higher-yielding stocks may or may not be solid investments. Simply looking at the yield will not tell you how well the company is run, and consequently how sustainable the dividend might be in the future. If you are seeking higher yielding stocks, it is important that you do some research here as well. What percentage of the company’s profits are being paid out as dividends? How does this compare with other companies in the same industry? What is the company’s history of paying dividends? Again, all of this can be researched on sites like Morningstar and CNBC, as well as on the company’s website.
- Mutual funds and ETFs offer a number of dividend-related strategies. There are dividend-growth funds which often focus on companies with a record of increasing their dividends. There are dividend-oriented funds that focus on yield as well. In either case, a fund or ETF might be a good option for smaller investors or those uncomfortable picking individual stocks. Funds and ETFs might be a good route for you if you are not comfortable with doing the research on individual stocks outlined above.
Advantages of dividend-paying stocks
Dividend-paying stocks can offer a number of advantages for investors, including:
Preferable tax treatment
Qualified dividends are taxed at lower capital gains rates.
- Dividends must be paid by a U.S. company or a qualified foreign company.
- Dividends must not be listed by the IRS as not qualifying.
- The stock must be held for a qualifying period which is generally 121 days (60 days before and after the ex-dividend date) for common stock and a similar 181 day period for preferred shares.
The tax rates for qualified dividends are as low as 0% for those who fall into the 10% or 15% tax brackets for ordinary income and is capped at 20% for qualified dividends regardless of your income. For those in higher tax brackets, the savings can be significant. Dividends received in a tax-deferred account like an IRA do not have tax issues when received, but will be taxed down the road when the money is withdrawn unless the account is a Roth IRA and the withdrawals are considered to be qualified.
Dividends provide a source of ongoing income while you hold the shares with the possibility of price appreciation over time. While there are no guarantees on price appreciation, you will earn income on a regular basis.
A few areas of caution about dividend-paying stocks
Dividend-paying stocks are still stocks
Some investors may look at dividend-paying stocks as an income-producing substitute for bonds, but it’s important to remember that these are still stocks. As such, dividend-paying stocks are still subject to the risks that accompany investing in stocks in general.
There are no guarantees
Dividend payments are not guaranteed. Companies can reduce or eliminate them at will if their financial condition warrants.
Dividend stocks and retirement
Dividend-paying stocks are often touted as an investment for those nearing and in retirement. Christine Benz, Director of Personal Finance at Morningstar, discussed a number of issues surrounding dividend-paying stocks and retirement.
Benz mentioned that dividends can help provide a stream of steady income to offset the loss of income from working. She added that unlike bonds, dividend-paying stocks offer the potential for growth.
“The ability of a company to continually pay dividends is a proxy for quality and financial stability,” Benz said. “These types of stocks can be an important part of a retiree’s portfolio, they are generally more stable but also offer some protection against inflation.”
She cited the example of the Vanguard Dividend Growth Fund (VDIGX) that invests in stocks with prospects for continued dividend growth. While the fund lost 25.57% in 2008, this was far less than the 37% loss suffered by the S&P 500 Index in the same year. As readers might recall, 2008 was the height of the financial crisis. Over the past ten years ending November 30, 2018, the fund trails the S&P 500 by about 100 basis points.
Benz cautioned against assuming that dividend-paying stocks will always be a stable, reliable investment during retirement. She cites the example of bank stocks during the financial crisis. Many stocks in this sector were consistent dividend payers until the financial crisis when many major banks were forced to slash their dividend payouts in the wake of the contraction and the panic in much of our financial system. Many investors saw their dividend payments cut and also saw the price of these stocks drop.
Overall when looking at building a retirement portfolio, dividend-paying stocks can play a role, but these stocks need to be evaluated on their merits just like any other investment holding.
Investing in dividend-paying stocks can be a potentially lucrative investment strategy for your portfolio. But remember, it’s important to understand what you are investing in, how sustainable the dividends are and most importantly to look beyond the stock’s (or the fund’s) dividend yield alone when determining if it makes sense as one of your holdings.