Investing in dividend stocks is one of the most effective ways to earn a considerable passive income. With dividend stocks in your portfolio, you can easily collect dividends quarterly. However, it can be challenging to know how dividend investing works, what dividend stocks to buy, and when to buy them.
In this article, you will learn how to start with dividend investing, pick the best dividend stocks, and important dates, such as the ex-dividend date, record date, and payout date, when investing in dividend stocks. I will also cover tips on identifying stocks with good dividend yields, how dividend reinvestment works, and the importance of diversification when investing in dividend stocks.
Here is everything you need to know about dividend investing.
What is a dividend?
Dividends might sound like an alien term for most stock market newbies. But you don’t need a college degree in finance to understand what dividends are.
In a nutshell, dividends are distributions of a company’s profit to its shareholders. Being a shareholder means owning at least one share of a corporation. For example, if you own shares of Tesla stock, then you are considered a shareholder. If Tesla is profitable and earns a surplus, it might distribute some of that profit to its shareholders. Everyone who owns shares of Tesla stock will receive a portion of its profit through dividend payments.
That means if you own shares of Tesla or any other company that pays dividends, you will be paid an amount proportional to the number of shares you own. The payment you receive is known as a dividend, and it is paid on the dividend payout date.
What is dividend yield?
Another important term to remember when buying stocks for dividends is the dividend yield. The dividend yield is the dividends per share. In order words, the dividend yield represents how much you will be paid in dividends for every share of XYZ company that you own. The dividend yield is expressed as a percentage, such as 5%, by dividing the dividend by the company’s share price.
What are dividend stocks?
If you are interested in buying dividend stocks, you must first know what they are. Dividend stocks are stocks from companies that pay dividends. The board of directors decides the amount of dividends available for distribution. The portion of the corporation’s earnings not paid in dividends gets reinvested into the business.
To buy stocks for dividends, you must find stocks that regularly pay dividends with higher dividend yields.
Another important term to remember as a dividend stocks investor is the earnings per share or EPS for short. The earnings per share is a profitability ratio that shows how profitable a company is per share of its stock. To calculate the EPS, you will divide the company’s profit by the outstanding shares of its common stock.
A lot of people confuse earnings per share and dividends per share. Earnings per share use the total profit of a business to calculate how profitable the business is compared to its share price. Dividends per share estimate the portion of the company’s earnings paid to shareholders. That is why, when calculating EPS, you divide the earnings by share price, whereas for dividend per share, you divide the dividends (a small portion of earnings) by the company’s share price.
Important dates to consider if you want to buy stocks for dividends
Besides knowing the right stocks to buy for dividends, you must also know the right time to buy to qualify. Just because you purchased shares of your favorite company does not mean you will get paid dividends.
Important dates to consider when buying stocks for dividends
Ex-dividend date
The ex-dividend date is the date a stock trades without dividends. If you buy dividend stocks after the ex-dividend stocks, you will not be eligible for a dividend payout. You must buy dividend stocks before the ex-dividend date to qualify for dividends. The ex-dividend date is crucial for dividend stock investors because that is when the share price drops by the amount of dividend paid to investors. For example, if the share price was $100 before the ex-dividend date, and the company decides to pay $1 per dividend share, the share price will drop to $99 on the ex-dividend date. Missing this date automatically disqualifies you from dividend payouts in that quarter.
Record date
Before you can get paid dividends, your name must be in the company’s books as a shareholder. The date on which you are recorded as a company shareholder and, therefore, eligible for dividends is the record date. Typically, the record date is one business day after the ex-dividend date.
Payout date
The payout date is the date you receive your dividends payout. If you own 100 shares of a company and it pays $0.5 per share, for example, you will receive $50 in dividends. Again, to qualify for dividend payout, you must first be recorded as a shareholder on the record date. For this to happen, you must buy dividend stocks before the ex-dividend date.
How long do you need to own stock to get a dividend payout?
To qualify for a dividend payout, you must be recorded as a company shareholder on the record date. For this reason, you must buy your dividend stocks before the ex-dividend date to qualify for a dividend payout for the following quarter.
How often do companies pay dividends?
Most companies pay dividends four times per year (every quarter). This is because companies report earnings every quarter, and therefore if there is any profit to distribute, it gets shared every quarter. Keep in mind that this is not a rule. At the end of the day, the board of directors decides whether dividends should be paid and how much. Don’t be surprised if your company pays dividends for one quarter and skips the next one.
Your company can also eliminate dividends due to financial constraints, such as paying off debts or reinvesting its earnings for product development and business growth. It is all about profitability and what the board of directors sees fit for the company.
Ordinary dividends vs. Qualified dividends
When you buy dividend stocks before the ex-dividend date, you risk having your dividends classified as ordinary by the IRS. By default, all dividends are classified as ordinary. But, when dividends meet some IRS specifications, they become qualified. Being qualified means that your dividends get reported to the IRS as a capital gain instead of an income, according to Investopedia.
Ordinary dividends get taxed as ordinary income. Qualified dividends, on the other hand, get taxed as a capital gain with a more favorable tax rate.
- Ordinary dividends. Any dividend payout you receive for stocks you own less than 60 days before the ex-dividend date. This dividend will be taxed as an income rather than capital gain.
- Qualified dividends. Any dividends you receive from dividend stocks you owned for more than 60 days before the ex-dividend date. The IRS treats this dividend payout as qualified dividends, giving you a more favorable tax rate.
Before buying dividend stocks
Although it might be tempting to buy stocks for dividends, it could be a risky game financially if your timing is not right. You must buy stocks before the ex-dividend date to qualify for dividends for the next quarter. If you miss this date, you won’t be registered as a shareholder on the record date, and therefore, you will not qualify for a dividend payout.
In addition, buying dividend stocks does not mean your net profit will be positive after receiving your first dividends. As I said earlier, the stock price will drop an equal amount in dividends per share. This means that the stock will go down in value, which will impact your portfolio.
Also, if you just bought dividend stock, the IRS might classify your dividends as ordinary because you have not held the stock long enough. For this reason, the tax liability on your dividend will be the same as an income tax. Hence paying more in taxes. So, the dividend payment you will receive might not be enough to offset the stock price drop and higher tax on your ordinary dividends. Under these circumstances, you might realize a negative net return.
How do you identify stocks with high yields?
Millions of people find picking the right stocks for dividend investing a bit tricky. Even people with finance degrees often find it harder to pinpoint stocks with the best dividend yields.
However, you can easily pick stocks with the highest dividends with the right strategies. As an investor, you should focus more on the company’s projected financials. This is because current dividend yields do not reflect a company’s future performance.
Tips to select the best dividend stocks with high dividend yields
- Expected earnings growth. Since dividends are all about profitability, stocks with the highest dividend yield are those with higher long-term expected earnings growth. Expected earning growth between 5% to 15% is considered good.
- Stick to companies with lower debt-to-equity ratios. No company will issue dividends when it is struggling to cover its debts. For this reason, ensure that the current and expected future debt-to-equity ratios of the companies you select are low.
- Strong cash flows. Strong companies with good dividend yields always have strong cash flows. Cash flows represent the amount of money a business brings in or spends over time.
- The company’s industrial strengths. We are in a competitive market where companies close their doors daily. Others get bought by their competitors to stay afloat. So, if you are interested in buying stocks for dividends, focus on stocks with industry dominance.
How much money can you make from dividend stocks?
Many factors will influence how much money you can make with dividends. But, the two most important factors to consider are the dividend yield from each stock you own and the number of shares you own for each stock.
For example, if you own 1,000 shares of XYZ company and it pays $0.25 per share, you will receive $250.00 in dividends. But, if the company paid $0.5 and you had 5,000 shares, your dividend payout would be $2,500. The higher the dividend yield and the number of shares you have, the more you will earn.
So, to earn more money in dividends, you need to pick the best dividend stocks with consistent dividend growth and buy as many shares as you can afford. As you accumulate the number of shares and re-invest your earnings, you will earn more passive income in dividends.
How much must you invest in dividend stocks to make $25,000 in passive income?
Although there is no minimum amount you need to invest in dividend stocks, you must have a sizable portfolio to have a great return. The biggest question you need to ask is”How much money do you need to make in passive income with dividends?”
For example, how much should you invest to make $25,000 in dividends? As I stated above, the dividend yield plays an important role in how much you can earn. The higher the yield, the more you will earn in dividends, even if the number of shares you own stays the same. For example, if the company pays $7 in annual dividends and the share price is $140, the dividend yield will be 0.05 or 5% (7/140). So, if you own one share of this company, you will earn an annual dividend payout of $7 for that one share.
Most companies, however, do not pay that much money in dividends. The dividend yield payout is much lower than this example across many industries. According to GuruFocus, the average S&P500 dividend yield is 1.69%, historically ranging between 1.62% and 2.10%. Since the S&P500 is a general benchmark for the stock market, we will assume average returns in the same ranges.
Assuming that your portfolio returns the top range with 2.1% on average, how much will you need to invest to make $25,000 in dividends?
To solve this puzzle, assume that X represents the money you need to invest. By multiplying that amount by the dividend yield, which is 2.10%, you will get $25,000.
So, X*2.10% = $25,000. We can now solve for X=$25,000/0.021 = $1,190,476
In order words, if your main goal is to make $25,000 in dividends, you must invest $1.2 million in dividend stocks with an average dividend yield of 2.1%.
How do you pick the best dividend stocks to buy?
This is a million-dollar question regarding finding the best dividends to buy. This is because there are a ton of dividend-paying companies, and therefore, it is hard to choose one or evaluate all of them. So, how do you know the best dividend stocks to buy?
Beyond the financial complexity of dividend-paying companies, some fundamental values still make a company good for dividends. Here are tips to pick the best dividend stocks.
A high yield does not mean the stock is better.
Many people make the big mistake of chasing high-yield dividends. Paying higher dividends could mean that the company is not investing in itself for future growth and profitability. You might receive higher dividends now, but the company’s future might be grim when its competitors start eating into its market shares.
Evaluate the dividend growth.
One of the key indicators of the best dividend stocks to buy is the growth of its dividend payout over time. By default, growth companies pay more dividends over time. If a company has been reporting steady growth in dividends, it will likely continue to report more dividends in the future. You should avoid companies cutting dividends due to financial constraints and market share drops due to competition or lack of product development.
Understand the risk of the company’s sector.
There are many sectors to consider, and some are riskier than others. When assessing whether a dividend stock you want to buy is good, scrutinize its sector. If the sector is dying or is subjected to high risk, think twice before buying its dividend stocks. Some of the most stable sectors with regular dividend payouts include the following.
- Oil and gas
- Banking and financial sector
- Utilities
- Healthcare and pharmaceuticals
- Materials
Look at the balance sheet
A strong balance sheet is essential to ensure a steady dividend payout. Too much debt is not good, and companies that report a few dividends here and there are also not good.
Focus on fully established companies.
Although growth companies might be more promising, it is wise to focus on fully established companies if you are only interested in earning dividends. This is because large and established corporations have their feet in the market and are already profitable and stable. The share price might not increase that high, but your dividend payout will always be guaranteed.
Stay away from less established companies.
Just because a company is profitable and pays dividends does not mean it is the best dividend stock to buy. Less established companies tend to reduce or eliminate their dividends due to financial constraints.
Buy a fund
If you have difficulty choosing the best dividend stocks, consider buying a mutual fund or fund-related securities. Instead of buying a single stock or two, buy dividend-tallied funds. These funds put a ton of research into their investments. By buying a fund instead of an individual stock, you will benefit from the fund’s research and fully diversify your investments.
Where to buy dividend stocks?
There are two ways to buy dividend stocks: doing it yourself(DIY) and using a financial advising firm.
- DIY dividend stocks. If you buy or invest in dividend stocks, you must research, open, and manage your accounts. You will need a good brokerage account to purchase shares of any securities you want. If you are getting started with dividends and the stock market, generally, open a brokerage account with a fully established brokerage firm. TD Ameritrade(AMTD), Merrill Edge, Fidelity, and Charles Schwab are the best brokerage companies. These platforms also have extensive educational material that can help you get started. Stay away from Robinhood, Public, Acorns, M1 Finance, etc. Although these apps offer ways to buy and sell dividends stocks, they do not offer enough educational material or advanced technical and fundamental analysis guidelines about companies and the market in general.
- Use an investment company. Not everyone is meant to flip stocks and understand the jargon of the stock market. There are always alternatives for those unwilling to get their feet wet. A financial advising company can do all the work for you.
Things to keep in mind when buying dividend stocks
Buying dividend stocks comes with the risk of volatility. As your shares of dividend stocks go up and down in value, so will your portfolio. Your favorite dividend company can also go out of business. An economic setback can shake the market and make you lose money. In other words, just like any other investment, investing in stocks that pay dividends comes with the risk of losing your investments.
In addition, investing in dividend stocks is not a get-rich-quick path. You cannot expect to earn millions of dollars from dividends when investing a few thousand dollars. Again, the amount you earn from dividends will depend on the dividend yield and the number of shares you own. The more shares you own and your dividend yield, the higher your dividend payout will be.
How does dividend reinvestment work?
As a dividend investor, you must choose whether you will receive your dividends in cash value or reinvest those dividends to buy more shares. Reinvesting your dividends means that once dividends are paid, they will be used to buy more shares of the company or fund that paid you dividends. In a downturn, dividend reinvestment can help you lower the risk of owning company shares through dollar cost averaging.
Why is diversification important when investing in dividend stocks?
Due to volatility, the risks involved with stocks and stock-based securities are extremely high. A shift in economic conditions can devastate your company, its sector, and the general market. Always diversify your portfolio to hedge against the potential loss of capital.
Regardless of your security or your belief in their financials, you should always diversify your investments. To properly diversify your portfolio, buy dividend stocks from different investment sectors with strong earning returns.
As an investor, putting all your money in stocks would be unwise. You should look into other investments that are not stock-related, such as bonds, gold, real estate, international securities, etc. Otherwise, a stock market crash can leave you with no dividends and expose your portfolio to the risk of losing an entire capital.
Benefits of dividends on your portfolio
Investing in dividend stocks comes with a lot of financial benefits. Having dividends means your portfolio will grow over time as you earn and reinvest dividends. If you don’t want to reinvest your dividends, you can have steady payments from dividends in your account. Dividends can also offer you tax advantages and lower your portfolio risks. For example, if you have bought a stock and its share price went lower, the dividend payments can help offset that loss and preserve your purchasing power.
