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If you could invest in companies that would pay you cash just for buying shares of their stock, why wouldn’t you?
That’s what dividend, value, income or blue chip-investing is all about. And it’s an approach that billionaires like Warren Buffett and other very wealthy investors have followed--continuously buying stock in well-established, dividend-paying companies, or “blue chips”.
Dividends represent a portion of a company’s earnings that’s returned to shareholders, essentially as a gift for investing. Why do that instead of putting that money into the company itself--or into the pockets of its executives? Companies see it as an incentive for investors to stick with them, even when the share price fluctuates, and a way to attract new ones.
The cynic in you may wonder: What’s the catch? Some critics do argue that dividends may ultimately decrease a company’s value since the company is not then investing that money in hiring more employees, say, or paying down debt obligations. Others assert that a company’s only offering them to make up for slow, or no, growth in the stock price. (Companies that are in growth mode, like newly public startups, typically do not pay dividends.) But Buffet’s no idiot. Many well-established companies have been paying them consistently for years, even as their share prices have soared. And while share prices go up or down, dividends can provide a steady, reliable income stream--and a guaranteed return on an investment that has no other guarantees.
Before you dive in further though, here’s what you need to know.
Remember the Dates
The Declaration Date is the day a company’s Board of Directors announces its intention to pay a dividend (e.g. when and whether it will that year). You can find this (and the other dates) on dividend.com or on the company's website. The Ex-Dividend Date is the day when shares that are bought no longer have a right to be paid the most recent dividend. (In other words: Check the ex-dividend date before you buy the stock to make sure you don't miss out.) If you already own shares, you're fine. Existing stockholders will get the dividend even if they sell the stock. But anyone who buys the stock on or after the ex-dividend date will not receive the most recent dividend. It is common for a stock’s price to decrease on the ex-dividend date by an amount close to the amount paid in dividends. Finally, the Payment Date is the day dividend checks will actually be mailed to you or credited to your brokerage account.
Do the Math
You're probably wondering how much money you can expect to get in dividend income. This one's pretty easy. Let's say you own 1,000 shares of Coca-Cola and the company is paying a quarterly dividend of 50 cents. Mutliply .50 times the number of shares you own (1,000), and that's how much you can expect to get: $500 a quarter. Not bad.
Now, if you want to figure out if you'll get more in dividend income from one particular company than from another, you'll want to figure out their annual dividend yields. The dividend yield essentially represents your guaranteed return, but it fluctuates along with the price of the stock. Yield is calculated by dividing the annual dividend per share by the current price per share (or you can use the 52-week average price). So, if you own those same shares of Coca-Cola, which (for our example) pays a quarterly dividend of 50 cents, and the stock price is $50 then your annual dividend yield would be 4 percent (50 x 4 / 50). If the stock price increases to $100 and the dividend remains the same, then it becomes 2 percent. If you don't want to do the calculations by hand, try this simple dividend yield calculator. It's important to note: The more stable a company and its stock are, the more stable the dividend will be, which is an especially important feature for investors relying on dividends for income.
Check Out the History.
Seasoned value investors seek out stocks that have a dividend yield that is higher than the interest yield on United States Treasury bonds and companies that have had a long history of stable and increasing dividend payments. You can usually find out information on a company’s dividend history by going to their website and looking in their “Investors” or “Investor Relations” section. Examining a stock's past dividend payouts can provide you with a good idea of future dividend trends. If a company has a history of dividend cuts or increases, they are likely to continue doing the same in the future. Avoid stocks with a history of stagnant dividend payouts (e.g. look for those with increasing dividend amounts) and beware of stocks with extraordinarily high yields (which could be a sign of business trouble). In general, look for stocks with a current dividend yield between two and five percent and a solid history of increasing dividends.
Look for a Low Dividend-Payout Ratio.
The dividend-payout ratio tells you the percentage of profit that is being used to pay dividends and is calculated by dividing the annual dividend per share by the company’s earnings per share or net income (this can be found under “financials” on most stock research sites). Or try this calculator. The dividend payout ratio is a good indicator of the reliability of future dividends and the overall health of a company. A high ratio is a red flag. As a general rule, avoid investing in companies with a ratio of more than 60 percent, as it might mean the company’s growth potential is dwindling.
Check the Payment Frequency.
Dividend frequencies vary. There is no dividend rate standard and companies can pay their dividends annually, bi-annually, quarterly or monthly. Quarterly dividends are most common, but if you’re depending on dividends for income, you'd probably prefer to get them monthly.
Who pays the most frequently? Look to real estate investment trusts (REITs), which offer more frequent payouts due to the collection of monthly rent revenue, or dividend-focused mutual funds or ETFs, which can contain a multitude of investments with different dividend rates (click here for a list of dividend-paying ETFs). In addition to recurring dividends, some companies reward investors with special, extra dividends when they receive an influx of cash. These non-recurring dividends are added to the amount of total annual recurring dividends to calculate the dividend rate. For example, if a stock pays a $0.50 dividend on a quarterly basis and paid an extra dividend of $0.12 per share, the dividend rate is $2.12 ($0.50 x 4 + $0.12) per year. Depending on the company's preferences and strategy, the dividend rate can be fixed or adjustable.
Know the Tax Implications.
For tax purposes, dividends are considered either “qualified” or “nonqualified” and are treated differently by the IRS. Qualified dividends are associated with the stock of U.S companies. Dividends passed through by mutual funds or ETFs can be qualified or nonqualified, depending on the underlying securities held by the fund, and will be passed on to shareholders as such. Distributions from real estate investment trusts, for example, are typically not considered qualified dividends. Qualified dividends are tax-free for those in the 10 and 15 percent brackets -- as long as qualified dividend income remains within those brackets -- and are taxed at a 15 percent rate for those in the 25 percent or higher tax brackets. Just be sure to hold onto the dividend-paying stocks for more than 60 days including the ex-dividend date (or 90 days for preferred stock) to qualify for the special tax rate. BUT nonqualified dividends are taxed at the same rates as ordinary income (currently a 35 percent maximum) and, in the case of stock owned in foreign corporations, the dividends may also be subject to a foreign withholding tax.
Get Acquainted With the Aristocrats.
There are a select few dividend stocks that not only have offered dividends for years, but also have increased their dividend on an annual basis. These are known as Dividend Aristocrats. This exclusive list of companies have not only consistently offered a dividend, but have also increased it annually over the past 25 years. Income investors love the Aristocrats, because their dividend return increases over time, helping to offset the negative effect of inflation. So while you may start with a relatively small annual dividend return, an investment in a Dividend Aristocrat can really pay off if held over a 10, 20 or 30-year time-frame. For a current list of Aristocrats, click here and then click on “Constituents” tab on the black box to download an Excel spreadsheet.
Know the Risks.
Traditionally, stocks that pay dividends are more stable and less exciting than stocks that don’t pay dividends and focus on growth. Take Microsoft and Apple as an example. Even though they are both well-established companies, for years Apple didn’t pay a dividend and instead used its profit to reinvest primarily in product development, while Microsoft steadily paid dividends to happy income investors. The result was that Apple’s stock price exploded (up 30 percent over the past 15 years) while Microsoft’s stayed mostly stagnant (up only 2.85 percent over the past 15 years). Interestingly, so far this year Apple stock has been down almost 14 percent while Microsoft is up over 20 percent, thanks to recent investment in acquisitions and product development. So, it goes to show you that patience and loyalty can pay off in the long run, while chasing returns can hurt you in the short term. It is also important to keep in mind that even dividend-paying stock from stable, profitable companies with long histories can still lose significant value and should not be considered a “safe” investment.
Max Out Your Returns.
While a carefully constructed dividend portfolio can provide a steady stream of income, it can be extremely worthwhile to reinvest your dividends. If you’re a long-term investor, reinvesting dividends can help you compound your investment growth over time and allow you to obtain additional stock shares at varying price points, reducing the potential impact of buying too high. Most brokerage accounts allow you to set up automatic dividend reinvestment plans, or you set up a dividend reinvestment plan (DRIP) with an individual company in which you own stock. Click here to learn more about DRIPs and which companies offer them. Keep in mind, though, that DRIPS make it very challenging to keep track of your cost basis, which you need to do for tax purposes. Your cost basis is the amount you paid for your investment, after factoring in items such as dividends, capital distributions, or stock splits. When you sell a taxable investment — such as stock or mutual fund shares in a regular brokerage account — this figure is needed to calculate your capital gain or loss. The good news is that brokerages and fund companies are increasingly offering sophisticated tools to help you more easily track cost basis. Another bonus: chances are you won’t have to pay commissions when you reinvest dividends into individual stocks or ETFs.