There are many different investing paths to choose from, day trading, options trading, swing trading, value investing, growth investing and lots of others. For myself and many others, including Warren Buffet whose portfolio is roughly 90% dividend stocks, dividend growth investing is the most appealing. Before we talk about dividend growth investing it’s important to understand exactly what dividends are.
What Are Dividends?
A dividend is an amount of money that is paid by a company to its shareholders. You’ll receive a specified amount of money for each share that you own. For example, if you own 10 shares of Company A who announces a $1.00 dividend you will receive $10.00 on the date specified. Dividends are usually paid on a quarterly basis but they can also be paid monthly or semi-annually. Dividend payments can range anywhere from less than 1% to upwards of 20% of the share price. Though, companies that have a high dividend yield may not be able to sustain such a payment, choosing stocks solely on their dividend yield is extremely risky and not advised. Use these Four Dividend Evaluation Methods to help you choose stocks for you portfolio instead.
Three Types Of Dividends
There are three types of dividend payments you may receive, cash, stock and extraordinary.
The most common type, a cash dividend is simply what it states, a payment from a company you’re invested in, in the form of cash.
A stock dividend is similar to a cash dividend except instead of paying shareholders with cash, they are paid with partial or wholes shares of the companies stock.
An extraordinary dividend is a one time distribution of cash or stock to shareholders. This is also referred to as a “special dividend.” These dividends usually occur if a company makes an exceptional profit during a quarter or period.2
Record Date and Ex-Dividend Date
The record date is the date announced by a company to determine which shareholders are eligible to receive a dividend.
The ex-dividend date is usually set two days before the record date and it is the date in which you must own shares of a company in order to receive a dividend. If you purchase a stock on its ex-dividend date or after, you won’t be eligible to receive the most recently declared dividend.
As long as you own a stock on the ex-dividend date you’re entitled to the dividend payout even if you sell your shares after the ex-dividend date. Buying a stock before its ex-dividend date and then selling after (but before the dividend payment date) and still receiving the dividend is a common strategy called a Dividend Capture Strategy. In a perfect world, the stock will drop equal to the amount of the dividend, but we don’t live in a perfect world and that’s why this strategy is plausible.
It is important to know that long term capital gains are taxed differently than short term gains or ordinary income. A long term investment is one that has been held for longer than one year. The personal income tax rate is always significantly higher than the long term investment tax rate, as you can see by the chart. Long term investments can save you big come tax time and that’s one of the biggest benefits of dividend growth investing. You can learn more about this here.
Disclaimer: Non-qualified dividends come from REITs, MLPs, tax-exempt corporations, and foreign corporations. These non-qualified dividends are taxed at your personal tax rate rather than the long term investment rate.
Dividend Aristocrats and Dividend Kings
Dividend Aristocrats are companies within the S&P 500 that have been paying an increasing dividend for at least 25 consecutive years.
Dividend Kings are companies within the S&p 500 that have been paying an increasing dividend for at least 50 consecutive years.
Aristocrats and Kings are a great place to begin researching stocks for your own dividend growth portfolio.
**It is important to note that since 1930 roughly 40% of the total U.S. stock market returns have come from dividends.**
What Is Dividend Growth Investing?
Dividend growth investing is a form of investing that focuses on dividend growth, obviously right? Obvious indeed, but the uniqueness of this style of investing allows your money to grow in a way like no other form of investing does. In the previous example with Company A let’s assume that was your first year investing. At the end of your first year Company A announces a 5% dividend increase, from $1.00 per share to $1.05 per share. Let’s also assume they continue to increase their dividend by 5% for the next 10 years. At the end of the 10 years your $1.00 per share dividend ( $10.00 ) would have increased to $1.63 per share ( $16.30 ) with no extra money invested. This is a small scale example for simplicity sake but it properly illustrates the premise of dividend growth investing. This is the unique compounding effect of dividend growth investing.
Long Term Approach and DRIP
A dividend growth approach is almost always seen as a long term approach. There are many benefits to this, including the tax benefits we talked about earlier. In addition to the tax benefits, you can plan on paying less in broker fees because you’ll be buying and selling much less frequently. Historically, dividend stocks tend to do much better than their non-dividend paying counter parts during a down market as well. In a dividend growth approach, a pull-back in the market usually means discounted stock prices and a prime buying opportunity.
DRIP- Direct Reinvestment Plan. When you sign up with a broker you usually have the option to enroll in a DRIP plan. This means that when you receive a dividend payment it will automatically be used to purchase fractional or whole shares of the company that paid you the dividend, rather than the cash sitting dormant in your account.
A DRIP plan can be advantageous as time is always a factor, but I want you to consider another option as well. If you receive a dividend from a company whose stock price is at an all time high, is it really the best time to invest more money into that company? Maybe it is, maybe it isn’t. There’s really no way to know for sure, but an alternative to this method is to receive your dividend payments in cash and manually redistribute them into stocks that are valued better at that time. It does take more work but, the payoff can certainly make it worth it.
Another advantage to dividend growth investing is the income. In a non-dividend paying stock you only have one way to make or lose money, capital gains or capital losses. Thus, the only way to make any real money (not paper money) is to sell your shares for a capital gain. With dividend growth investing you can make paper money from your capital gains and make real money from your dividend payments without having to sell any of your shares. Dividend income is a great form of passive income and it’s what inspired the name of this blog.
How To Calculate Yield
It’s fairly simple to calculate dividend yield once you get the hang of it. The yield of a stock is the return paid over one year. So for a dividend stock that pays quarterly, the yield is the sum of the last for quarterly dividends, divided by the price of the stock, multiplied by 100. For example, let’s say you buy AT&T (T) at $42.00 per share. And the last four quarterly dividends have been $0.48, $0.48, $0.48 and $0.48 giving a total of $1.92 per share. 1.92/42 = 0.04571429. Multiplied by 100 gives you a 4.57% yield.
How To Pick Dividend Stocks
There are four well known methods used to evaluate dividend stocks and they are: free cash flow to equity, dividend payout ratio, dividend coverage ratio and the net debt to EBITDA ratio. You can read more about these four methods here. Together they combine to form a solid method for picking dividend stocks to purchase. However, there are other factors to consider as well such as current price and upside potential.
Some Things To Be Aware Of
Please be aware that companies do not have to pay dividends and they can be cut at any time. In economic hardships, dividends are usually the first thing to go, or at least the first thing to be trimmed. This is probably the biggest risk involved with dividend growth investing.
I’ll say it again because it’s that important, don’t go chasing yield! High yield is appealing and why shouldn’t it be, but it’s far from safe. If you plan on investing in a company that pays a high yield do your due diligence and properly value that company to be sure that dividend is sustainable.
Also be aware that in a rising rate environment, like the one we’re currently in, dividend paying stocks may drop in price as people turn to other investments options such as CDs or bonds.
I hope those who were unsure have a better grasp on the concept of dividend growth investing. I also hope some of you may have been convinced to join myself and many others on the path to financial independence through dividend investing!
What’s your take on dividend growth investing?