There are many different investing paths to choose from like 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 a style that we like to incorporate. Before we jump into dividends and dividend growth investing it’s important to understand a few things that are involved.

What Are Dividends?

A dividend is an amount of money that is paid by a company to its shareholders. An investor will receive a specified amount of money for each share that they 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. 

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 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 whole shares of the company’s 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.

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 called the dividend capture strategy.

Tax Advantages

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 usually 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. 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

Aristocrats and Kings are a great place to begin researching stocks for your own dividend growth portfolio. 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. 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 is what is so intriguing. Let’s go back to the previous example with 10 shares of Company A. They were paying a $1.00 per share dividend. Assuming Company A increased their dividend by 5% for 10 years, the initial $10.00 received in dividends would have grown to $16.30. You didn’t have to invest any additional principal to receive the extra dividends and you likely would have seen share price growth as well. 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 strategy is a long term approach to investing. There are many benefits to this, including the tax benefits we talked about earlier. You can also 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 counterparts 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.

When you sign up with a broker you usually have the option to enroll in a dividend reinvestment plan (DRIP). 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. The alternative is that your cash will sit in your account until you manually reinvest it or withdraw it.

A DRIP can be advantageous as time is always a factor, but there is another option to consider as well. For example, 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 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.

Consistent Income

Another advantage to dividend growth investing is the income. With 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 receive money that you can use is to sell your shares for a capital gain. You will receive dividends without having to sell shares making it easy to get some money out of the market.

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. For a dividend stock that pays quarterly, the yield is the sum of the last four 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

You can use lots of different methods to pick dividend paying stocks. Here are four common methods to evaluate dividend stocks. Free cash flow to equity, dividend payout ratio, dividend coverage ratio and the net debt to EBITDA ratio. 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 market conditions.

Some Things To Be Aware Of

Be aware that companies do not have to continue 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. This highlights why chasing yield can be dangerous. High yield is appealing and for good reason, but it’s far from safe. If you plan on investing in a company that pays a high yield do your due diligence. Properly value that company to be sure that dividend is sustainable. Also be aware that in a rising interest rate environment, dividend paying stocks may drop in price. People will often turn to other investment options such as CDs or bonds.

What’s your take on dividend growth investing?

Wouldn’t it be great if you could just collect dividends without suffering the volatility that comes along with stock ownership? The dividend capture strategy aims to do exactly that. The basis of the strategy is to hold a stock just long enough to receive the dividend. Fundamentally, it is an easy strategy to apply but it could be considered a gamble in practice.

The Basics

It is important to understand a few basic concepts before attempting to implement the dividend capture strategy. Firstly, dividends are a portion of a company’s profits that are paid regularly to shareholders. They are usually paid quarterly but they could also be paid monthly. Many investors rely on dividend growth companies as a source of income due to low volatility, low to moderate risk and competitive yields. The dividend capture strategy can be especially useful when a less attractive company pays a very attractive dividend. Thus allowing one to capture the generous dividend without assuming the risk of holding the company for any longer than required.

Dividend Dates

It is important to understand dividend dates to successfully implement this strategy. The important dates to understand are the declaration date, ex- dividend date, record date and the pay date. 

Declaration date – This is the date in which the board of directors declares when the dividend will be paid and how much the dividend will be.

Ex-dividend date – This is the date in which investors must buy the stock before to receive the dividend. This is also the date in which the stock is supposed to be reduced by the dividend amount. 

Record date – This is the date in which a company reviews its records to determine which shareholders are eligible to receive the dividend. 

Pay date – This is the date in which shareholders will actually receive the dividend.

How It Works

Simply, buy a stock before the ex-dividend date and sell on or sometime after that date. After you have owned the stock on the ex-dividend date you no longer need to own the stock to receive the dividend. In theory, when a company pays a dividend the stock will drop by the amount of the dividend. In reality, there are three possible scenarios. These three scenarios will result in a loss, gain or breakeven outcome for the shareholder. 

Loss – Company 1 is trading at $30 per share and declares a $0.50 dividend. The stock is purchased before the ex-dividend date and on the ex-date it drops down to $29 per share. This would result in a loss of $0.50 per share, the difference between the $1 loss per share of the stock and the $0.50 dividend. 

Break even – Assuming the same scenario, Company 1 drops to $29.50 on the ex-date. This would result in a break even situation, no gain or loss. $0.50 loss per share recouped by the $0.50 dividend. 

Gain – Assuming the same scenario, Company 1 stays at $30 per share on the ex-date. This would result in a gain of $0.50 per share. Stock price stayed the same with a $0.50 dividend.

The dividend capture situation aims to take advantage of the third scenario. Since it could go either way there is a certain amount of risk involved with this strategy.

Precautions

Before going out and trying to implement this strategy there are some things you should consider first. Taxes, brokerage fees and other market factors can be detrimental to profits.

Taxes – There are certain tax advantages for holding stocks long-term. Ordinary income tax will be owed on all the gains received from this method. 

Brokerage fees – If you have a broker that charges per trade you’ll need to factor in the price of two trades. If your broker charges $5 per trade you’ll need to make an extra $10 to cover your buying and selling fees.

Market factors – There are an infinite number of factors that could affect the stocks price come the ex-dividend date. Acquisitions, law suits, interest rates, political factors, etc.

Lots of us read the stories about early retirees and turn green with envy. Many people don’t understand how to get to that point or how much money it really takes. The fact of the matter is that it’s different for everyone and it’s actually pretty easy to calculate how much you would need to live off dividends alone. We all have different goals, hobbies and things we would like to accomplish with our time. Most of these things require money and if they don’t require money, they require time which money buys you. Understanding your month to month expenses, the lifestyle you want to live and how to calculate how much you’ll need to achieve these things are crucial to achieving the goal of living off dividends.

Expenses

Before anything else you’re going to need to know exactly how much money you need to spend every month. This number is the absolute minimum you’ll need to retire early. Granted, you wouldn’t have any extra money after paying your bills, you still technically wouldn’t have to work. If your bills add up to $,1500 every month you’re going to need at least $1,500 per month in dividend income. Most dividends are paid quarterly so you’ll need to find your average monthly dividends and budget accordingly. If your expenses vary quite a bit every month then you can budget for yearly expenses.

Being diligent about tracking your expenses on a monthly basis is a must if you want to know how much you need to retire off your dividends. Tracking expenses creates a picture of your financial health that you don’t often see otherwise. Having this information available to you allows you to make changes and see exactly where you can cut back or where you’re overspending. Tracking your net worth is also extremely beneficial to understanding your current situation and for tracking progress. I use Personal Capital to track my net worth. It’s phenomenal, honestly. I login almost daily to keep an eye on things. If you want to check it out, use my link to sign-up

Lifestyle

This is the tricky aspect where personal preference comes into play. If you want to stay in a hotel every night and have luxurious things you’ll need much more money than someone who is content with taking one vacation per year and living a basic life. There’s no right or wrong answer here but the more money you want to spend while retired the more money you’ll need to have invested to generate that income. The trick is to find balance.

At what point are you still happy? Do you need to spend $60,000 on a brand new car or will a $10,000 used car work for you? Do you need to go out to eat 4 times a week or will 1 or 2 times a month work for you? Maybe you do want a more expensive car or to go out to eat more often. Just plan on having that extra money budgeted for every month. It’s all about sacrifice and deciding what’s important to you. Personally, I want to be able to travel when I retire. For me this means I need to be able to have extra money every month to afford travel expenses. I would like to travel at least 4 times a year. That means I’ll need to work longer so save more money to afford these expenses.

Calculating Dividends

This is pretty straightforward. If you bought 100 shares of AT&T, for example, the quarterly dividend at the time this was published was $0.48 per share. 100 shares x $0.48 dividend = $48. That’s how much you can expect quarterly (hopefully with increases over time). Or, $48 x 4 quarters = $192 yearly. Or $192 / 12 = $16 monthly. Simply do this math for all your stocks and that is your pre-tax dividend income. You will have to account for taxes as well depending on the bracket you will be in when you retire. Subtract your monthly expenses from your monthly dividend income and that’s how much you’ll have left over every month. Or you’ll know how far away you are from being able to afford your monthly expenses.

A Rough Estimate

If you want a simple answer to the question “how much do I need to live off dividends?” This is a method that could work for you. For example, say that you need $20,000 per year for your basic expenses and you’d like another $20,000 per year to spend. Take that $40,000 and divide it by .04. The result is $1,000,000. You would need to have $1,000,000 invested to receive $40,000 per year in dividend income if you can achieve a 4% yield. If you wanted to make $100,000 a year with an average yield of 3.5% then you’re going to need to have $2.85 million invested.

Overview

Everyone has different goals when it comes to retirement. You may just want to make the absolute bare minimum that you can so you can quit your job and never go to work again. Maybe you don’t want to retire until you can live the exact same lifestyle that you’re living now. Maybe you’re happy somewhere in the middle. These are the things that you need to consider and decide for yourself. The math is simple, it’s everything else that isn’t. Track your expenses, decide what makes you happy and what you really want to do with your life. I don’t want to slave away until I’m 63 but I want to be able to do things with my life as well. I definitely fall somewhere in the middle as I believe most people do. Find what works for you and start working towards it!

How much money would it take for you to begin your early retirement?

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