Dividend stocks are a highly sought after type of security on the stock market, with the potential to provide a great deal of money over a long period of time. But what are dividend stocks, and how should you invest in them to get the most out of them? Read on to find out more.
What are dividend stocks?
Dividend stocks, also known as income stocks, are a type of stock that distribute a portion of the company’s earnings, or “dividend payments,” to investors on a regular basis. Dividends provide valuable income for investors, which makes dividend stocks highly sought after in certain investment circles.
Mature companies are the most likely to pay dividends, with companies in the utility and consumer staple industries often having higher dividend yields. Most dividend stocks pay investors a set amount each quarter, and the top ones increase their payouts over time, which allows investors to build a cash stream, much like an annuity.
Investing in dividend stocks is a strategy that gives investors two sources of potential profit: the predictable income from regular dividend payments, and capital appreciation of the stock over time. Buying dividend stocks can be a great approach for investors looking to generate income or build wealth by reinvesting dividend payments, although as with all forms of investment it still comes with risk that should ideally be mitigated by effective money management techniques.
Important dates to know
There are three important dates to remember regarding dividends:
- Declaration date: The declaration date is the day the Board of Directors announces its intention to pay a dividend.
- Date of record: This date is also known as the “ex-dividend” date. It is the day upon which the stockholders of record are entitled to the upcoming dividend payment.
- Payment date: This is the date the dividend will actually be given to the shareholders of the company.
As mentioned above, a majority of dividends are paid four times a year on a quarterly basis, although some companies pay dividends on an annual basis.
Important metrics to know
- Cash dividend payout ratio: The dividend payout ratio is the percentage of earnings paid to shareholders in dividends, and is calculated by the dividends paid divided by the net income. This ratio indicates how much money a company is returning to shareholders versus how much it is keeping on hand to reinvest in growth, pay off debt, or add to cash reserves.
- Dividend yield: The dividend yield of a company is the annualised dividend, represented as a percentage of the stock price. For example, if a company pays $1 in annualised dividends and the stock costs $20 per share, then the dividend yield would be 5%. The dividend yield can be used as a valuation metric (by comparing a stock’s current yield to historic levels) and to identify red flags. A higher dividend yield is better, all other things being equal, but a company’s ability to maintain (and ideally increase) the dividend payout matters even more.
- Earnings per share (EPS): The EPS of a company is its net profit divided by the outstanding shares of its common stock, and serves as an indicator of the company’s profitability.
- Payout ratio: The payout ratio of a company is he tdividend as a percentage of a company’s earnings. If a company earns $1 per share in net income and pays a $0.50-per-share dividend, then the payout ratio is 50%. Typically, the lower the payout ratio, the more sustainable a dividend should be.
- Price-to-earnings (P/E) ratio: The P/E ratio relates a company’s share price to its EPS, calculated by dividing the market value per share by the EPS, and can be used to determine the relative value of the company’s shares.
- Total return: The total return of a company is the increase in stock price (or capital gains) plus dividends paid. For example, if you pay $10 for a stock that increases in value by $1 and pays a $0.50 dividend, then the $1.50 you gain is equivalent to a 15% total return.
Dividend investment strategies
If you’re a long-term investor looking to invest in dividend stocks, you should consider using a dividend reinvestment plan, also known as a DRIP. A DRIP is a program that allows investors to reinvest cash dividends into additional shares, or fractional shares of the underlying stock, on the dividend payment date.
Most DRIPs allow investors to buy shares commission-free or for a nominal fee, at a significant discount to the current share price. However, most do not allow reinvestments much lower than $10. While DRIPs are usually intended for existing shareholders, some companies make them available to new investors, typically with a minimum purchase amount.
If you’re building a portfolio to generate income today, it’s important to keep in mind that . With this in mind, you should consider investing in a dividend-focused exchange-traded fund (ETF) or mutual fund. These options will allow you to own diversified portfolios of dividend stocks that generate passive income.
A mutual fund is an investment vehicle consisting of a portfolio of stocks, bonds, or other securities. Mutual funds are operated by professional money managers, who allocate the fund’s assets to produce capital gains or income for investors. A mutual fund’s portfolio is structured and maintained to match the investment objectives stated in its prospectus. Mutual funds can be a useful way to diversify your portfolio, and have the benefit of being less volatile than other types of investment. An ETF is a type of investment fund that can be traded on an exchange, much like a stock. ETFs are similar to mutual funds in that both are investment funds, but where ETFs are bought and sold throughout the trading day, mutual funds are not traded on an exchange and only trade once a day when the market closes. You can find out more about the specifics of ETFs here.