Publicly traded companies can decide what to do with profits. They can reinvest them to grow the company and raise share prices or they can pay some of their profits to shareholders as dividends. A company that pays dividends may do so as a compensation to shareholders – compensation for being a higher-risk investment or for low growth in share values.
If you’re interested in dividend investing, a financial advisor can help you identify opportunities and manage risk.
What Is Dividend Investing?
Dividend investing involves buying shares of companies that pay dividends, essentially sharing their profits with shareholders. This method appeals to those looking for steady income, as dividends are typically paid out quarterly.
The advantage of this investment strategy lies in its dual earning potential: regular dividend payments provide a steady income stream, and there’s also the opportunity for capital appreciation if the stock price increases. This makes it a popular choice for investors seeking reliable returns.
For successful dividend investing, it’s important to choose companies with a consistent record of paying dividends and strong financial health. Look for businesses that have a history of profitability and a commitment to distributing profits to shareholders, which can lead to sustained and potentially growing dividend payments over time.
If you want to know how much income you could expect from a dividend investment, you will need to calculate its yield.
How to Calculate the Dividend Yield
A dividend yield calculates how much a company pays annually in dividends when compared with its stock price. The yield is shown as a percentage and investors use it to gauge how much income they could earn from a dividend, if they choose to buy a stock.
To calculate the dividend yield, you divide the annual dividends paid per share by the current share price.
For example, if a company pays $1 in dividends per share annually and the stock is priced at $20, then the dividend yield is 5%.
The formula to calculate the yield is:
- Dividend Yield = Annual Dividends Per Share/Current Share Price × 100%
A significant yield can sometimes be due to a drop in the stock price, which could indicate that the company is facing challenges.
Pros and Cons of Investing in Dividends
Investing in dividend stocks comes with specific benefits. Here are four common ones to consider:
- Regular income stream: Dividends provide consistent payments that can be crucial for retirees or those looking for stable income.
- Stability: Dividend-paying companies are often well-established and financially stable, resulting in lower investment risk.
- Reinvestment opportunities: Dividends can be reinvested to purchase additional shares, compounding returns over time.
- Predictability: Regular dividends can make financial planning easier due to the predictable nature of the income.
And, as with other financial investments, dividends also come with these four drawbacks:
- Lower growth potential: Dividend stocks typically offer lower capital appreciation compared to growth stocks, potentially limiting total returns.
- Tax liability: Dividends are taxable, which can reduce the net income that investors receive from their investments.
- Dividend cuts: During economic downturns, companies may reduce or suspend dividend payments, impacting income-focused investors.
- Market dependency: High dividend yields can sometimes be a sign of a company in distress, misleading investors about the health of the company.
How to Pick Dividend Investments
As noted earlier, if you want to invest in dividend stocks, you should first calculate the dividend yield to see how much a company pays out in dividends when compared with its stock price. Additionally, you should check the dividend payout ratio to ensure the yield is sustainable—this ratio shows the percentage of earnings returned to shareholders as dividends.
Then, consider the company’s history with dividends. Opt for companies that consistently pay and, ideally, increase dividends over time. This trend often signals financial stability and a commitment to shareholders. Additionally, make sure the company’s earnings are growing, which can indicate potential for higher dividends in the future.
Finally, diversify your dividend investments across different sectors to lessen risk. Industries respond differently to economic changes, and diversification can protect against sector-specific downturns. Carefully analyze each company’s financial strength, including debt levels, cash flow and earnings projections, to determine whether it could pay dividends moving forward.
Once you have picked your dividend investments, you may want to reinvest your dividends automatically into additional shares so that you could compound the growth of those investments. This can be done through a dividend reinvestment plan.
What Are Dividend Reinvestment Plans?
Dividend reinvestment plans (DRIPs) allow you to use your dividends to buy more shares of a company automatically, instead of receiving them as cash. This method is useful for those who want to grow their investments over time. By reinvesting dividends, you gradually increase your ownership in the company without having to make additional purchases from your pocket.
If you choose to enroll in a DRIP directly through a company, your dividends will automatically be used to purchase more of the company’s stock, boosting your investment. It’s important to keep track of how much you initially paid for your shares to accurately report taxes when you decide to sell.
Many brokerages also offer an option to automatically reinvest dividends from mutual funds and index funds at no extra cost. This approach allows your investment to compound the returns automatically. This hands-off approach not only simplifies managing your investment but also helps in achieving long-term financial goals like preparing for retirement.
What Is Ex-Dividend Date?
As a dividend investor, you should know the ex-dividend date of the stock that you want to buy. If you buy stock before the ex-dividend date, you’ll be included in the company’s next round of dividends. Your name will be registered on the list of shareholders in time for the “record date” that determines who gets dividends.
But, if you buy on or after the ex-dividend date, you won’t be included in the forthcoming dividend round. Don’t make the mistake of thinking that the record date is the deadline. It’s the ex-dividend date you really have to pay attention to.
Companies set ex-dividend dates to provide transparency to the dividend process.
Should You Invest in Dividend ETFs?
Investing in dividend ETFs can be a smart way to earn income from your investments. These funds group stocks that pay high dividends together so that you could earn from multiple companies without having to choose each individually.
When choosing a dividend ETF, you should look for ones with a record of increasing dividends over time, as these are more likely to continue offering reliable returns.
You should also keep an eye on fees associated with these ETFs. High fees can eat into your dividend earnings, so it’s best to choose funds with low expense ratios to keep more of your returns.
Additionally, don’t forget that dividend ETFs might not be diverse across different sectors. They focus on companies that pay good dividends, which could expose you to more risk if a single industry faces a downturn.
To reduce this risk, diversify your investments beyond just dividend ETFs. You can do this by adding a variety of asset types and industry sectors to your portfolio to help protect returns against market volatility.
Balancing dividend ETFs with other investments can create a more secure and resilient portfolio.
Bottom Line
Dividend investing can bring its rewards, but if you’re paying high fees and commissions for the privilege of chasing dividends, you may be undermining your results. Some people are under the impression that the price of dividend stocks is guaranteed to stay fairly stable. The theory goes that the payment of dividends protects the company from a dramatic drop in share prices. This is true – until it isn’t. Companies that pay high dividends have been known to crash and burn, which just goes to show you that investing has risks. In other words, it’s important not to base your entire investing strategy on chasing high dividends.
Investment Planning Tips
- A financial advisor can help you mitigate risk for your portfolio. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- If you want to know how much your investments could grow over time, SmartAsset’s investment calculator can help you get an estimate.
Photo credit: ©iStock/veerasakpiyawatanakul, ©iStock/Drs Producoes, ©iStock/filadendron