Introduction to Dividend Investing

September 14, 2022

Many investors swear by their dividend investing strategies. Dividend stocks have historically outperformed the S&P 500 with less volatility. For example, the S&P 500 is down around 15% from January to September 2022, while the FTSE High Dividend Yield Index, which tracks the return of large- and mid-sized companies that pay the highest dividends, is down just around 5% for the year.

What Are Dividends?

A dividend is the distribution of a company’s earnings to its shareholders. The company’s board of directors determines the dividend amount. Dividends are often distributed quarterly and may be paid out as cash or reinvestment in additional stock. 

How Do Dividend Stocks Work?

Dividend-paying stocks return dividends typically on a quarterly basis, but other schedules are also possible. Special dividends are one-time payments. A company’s board of directors must approve its dividend policy and announce its plans to investors through a press release or a filing with the SEC.

Who Are the Dividend Aristocrats?

The Dividend Aristocrats refers to a group of companies in the S&P 500 that have increased dividends per share for at least 25 consecutive years. The S&P 500 Dividend Aristocrats ETF (NOBL) allows investors to easily purchase these companies.

To be included in the Dividend Aristocrat group, a company must:

  1. Be a member of the S&P 500.
  2. Have increased the annual total dividend per share for at least 25 years straight.
  3. Have a float-adjusted market capitalization of at least $3 billion.
  4. Have an average daily trading volume of at least $5 million.

As of August 2022, the list includes 65 companies across sectors of the stock market, many of which are household names: Coca-Cola (KO), Walmart (WMT), and Exxon Mobil (XOM).

Key Dividend Metrics 

It’s important for beginners to know how dividends are evaluated. The following metrics can help explain how much in dividends to expect and how reliable the dividend might be. 

  • Dividend Yield: This is the annualized dividend represented as a percentage of the stock price. For instance, if a company pays $1 in annualized dividends and the stock price is $50, the dividend yield would be 2%. Yield is used as a valuation metric when comparing a stock’s current yield and its historic levels. While a higher dividend yield is better, it is more important for a company’s dividend to be consistent and ideally, increasing. So, an abnormally high dividend yield could be a red flag.
  • Dividend Payout Ratio: This is the dividend as a percentage of the company’s earnings. In simple terms, the lower the payout ratio, the more sustainable a dividend should be. 
  • Total Return: This is the increase in the stock price (known as capital gains) plus dividends paid.
  • Earnings per share (EPS): The EPS metric normalizes a company’s earnings to the per-share value. The best dividend stocks are companies that have regularly increased EPS over time, thus raising their dividend. A history of earnings growth is often cited as evidence of competitive advantages.

Important Dividend Dates

Dividend payments follow a chronological order of events, and the associated dates are essential in determining which shareholders qualify to receive the payment. 

  • Announcement Date: Dividends are announced by the company on the announcement or declaration date. 
  • Ex-Dividend Date: The date on which the dividend eligibility expires, meaning shareholders who purchase the stock after this date will not receive the next dividend payment.
  • Record Date: The record date is the cutoff date, established by the company to determine which shareholders are eligible to receive the distribution. 
  • Payment Date: The company issues the payment on the payment date. 

How Do Dividends Affect Stock Price? 

Announcements of dividend payments or dividend increases often cause the price of a stock to rise and then decline by a similar amount at the opening of the ex-dividend date. This is no guarantee as stock prices rely on a wide array of variables. 

In general, investors prefer companies that offer dividends because they are an indication of strong earnings and balance sheets and because they provide cash flow for investors. 

It seems counterintuitive, but dividend yield actually decreases as a stock’s price increases. The dividend yield is a ratio of how much cash flow you receive for each dollar invested in the stock. Because dividends are typically paid on a per-share basis, your dividend is determined by the number of shares and not by the market value of those shares. 

Why Do Companies Pay Dividends? 

Dividend payments help maintain investors’ trust in the company and reflect positively on its reputation. A high-value dividend can indicate that the company has generated solid profits.

Companies make the decision to pay dividends in order to keep investors and the market happy. Some companies may choose to make dividend payments— even when they don’t make suitable profits— to maintain their established track record of distributions and not disappoint their investors.

Common Dividend Investment Strategies 

Dividend stocks are often recommended to low-risk investors, but they can be part of an investment strategy for any investor. Dividend stocks, especially those in companies that consistently increase their dividends, have historically outperformed the S&P 500. 

Some people build a dividend portfolio as part of their overall portfolio. Or, investors could choose to invest in dividend-focused exchange-traded funds (ETFs) or mutual funds. These fund options enable diversification for investors. Dividend payers can be included in numerous investment accounts including brokerages and IRAs.

Investors looking for dividend income can also invest in real estate investment trusts (REITs) or master limited partnerships (MLPs). REITs are one of the most popular options for investors seeking regular income as they are required to distribute more than 90% of their earnings each year in order to maintain their filing status.

Dividend Yield

One approach to dividend stock investing is to purchase stocks or funds that offer high current dividend yields. These companies may be undervalued or could be facing some business challenges that have depressed their share price and pushed the dividend yield higher.

Dividend Growth

Some dividend investors choose to invest in companies that have consistently increased their dividends over time. These stocks will typically have a lower yield than high-dividend stocks, but they tend to have healthy underlying businesses as they’ve consistently been able to increase their payout.

Reinvesting Dividends

Investors will usually determine if and how they want to reinvest dividends. Some investors manually reinvest dividends, while others use a dividend reinvestment plan (DRIP).

DRIPs take every dividend you earn and reinvest it back into shares of that company without fees or commissions. This is a simple set-and-forget tool to put the power of time and compounding value to work.

Can Dividend Investing Protect Your Portfolio From Downturns? 

Stocks that pay above-average dividends are commonly considered safe havens during periods of economic uncertainty. Companies able to generate cash can use this cash in three ways: reinvest in their business, acquire or invest in other companies, or return to shareholders in the form of buybacks and dividends. 

Companies that start paying dividends tend to have enough excess cash flow to continue making payments for years. Companies that commit to paying dividends are usually reluctant to stop. 

If a company can commit to high-paying dividends, they likely have strong balance sheets and fundamentals.  In addition, the dividend itself can provide a cushion against downside risk. All else being equal, companies that pay dividends have less downside risk because dividend payments can help to offset price declines. 

However, rising interest rates have the potential to offset dividend gains. As rates rise, investors who have purchased dividend ETFs to boost their income investments may rotate out of high-yield stocks towards bonds or other assets, causing stock prices to fall.

This material is provided for informational and educational purposes only.  It is not intended to be investment advice and should not be relied on to form the basis of an investment decision.

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