In this article, I will cover the fundamentals of dividend investing and will show you how to invest in dividend stocks for income. This investment strategy is well-suited for investors who're looking for a stable, relatively-safe, and proven passive income strategy. However, it's not the best investment strategy for investors with a longer investment time horizon, those with less capital to deploy, and investors who're seeking higher-growth returns. Regardless, through investing in companies that consistently pay and grow their dividend payments, you can build a passive income machine that will consistently put money into your pocket.
By the end of this article, you'll have a strong dividend investment strategy that you can follow with confidence, and will be able to begin creating a portfolio of dividend stocks depending on your risk tolerance.
An Introduction to Dividends
Dividends are payments given out by publicly traded companies on the stock market to shareholders. Publicly traded companies all receive profit in some way or another. These companies can choose to either keep and reinvest all of the money they earn back into their business, and/or pay a portion of their earnings to their shareholders as dividends.
This means that dividend payments are NOT given out by every company in the major stock exchanges. However, companies that issue dividends regularly are typically more financially stable, with strong and predictable future expected performance and cash flows. Regardless, you must always remember that companies that choose to issue dividends have absolutely no obligation to payout dividends to their shareholders. Therefore, even if you received a dividend payment from a company a few months prior, there is no guarantee that you will receive another dividend payment in the future.
Despite this lack of obligation, the best dividend-paying companies will go to extreme lengths to pay out dividends to their shareholders, as it may be the main reason many shareholders are even invested in the business, There are also many indicators and measures dividend investors can use to ensure they're not investing in companies that will cut or reduce their future dividend payments, as later discussed in this article.
Dividend Payment Schedule
Dividends, from most publicly traded companies, are paid out quarterly each year. This all depends on the company, as dividends can be be paid out monthly, twice a year, or even three times a year. In general, you should avoid prioritizing one dividend-paying company over another based on how often it pays out dividends.
Dividends also get a declaration date a few weeks before they are paid out to shareholders. On this declaration date, companies will announce the per-share dividend amount that will be paid out to shareholders. This is typically done through a press release a few weeks before the dividend is paid out to shareholders.
To determine whether you're qualified to receive the next dividend payment, you should be aware of two important dates. First, the "record date" (aka "date of record"), and second, the "ex-dividend date" (aka "ex-date").
When a company declares a dividend, it sets a record date, in which you must have invested in the company as a shareholder to receive the dividend. Once this date is set, the stock exchange assigns an ex-dividend date. This is usually two business days before the record date.
Here's a Dividend Calendar which shows ex-dividend dates for every publicly-traded company.
If you purchase a dividend-paying stock before the assigned ex-dividend date for the company, then you will receive the next dividend payment. On the other hand, if you purchase a dividend-paying stock after the assigned ex-dividend date, then you will not receive the next dividend.
Here's an example table which will help you make sense of these dates:
How To Calculate Dividend Payments
If you owned 100 shares of stock of a particular company, and on the declaration date the company announces to the public that it would be paying out $1.00 per share, you would receive $100 (100 shares * $1.00). Clearly, this is rather straightforward, as the formula below also illustrates:
Dividend payment = Number of shares owned × Dividend per share
The Best Dividend Investing Strategy
If you follow this dividend investing strategy and stick with it for the long-term, I can guarantee that you will have an easier time generating cash flow when it comes to retiring.
To begin, if a company has a proven business model that is making lots of profit, they will likely be paying out more and more dividends over time. There is really no shortage of these companies. There are hundreds of companies that are constantly growing and have been growing over the past few decades when it comes to their dividend payouts.
When you combine this with companies whose share price is increasing over time, you'll get what is known as the double compound effect. It's not uncommon for dividend-paying companies to experience this effect as companies with consistent dividend growth tend to have share price growth as well.
Double compound effect = Dividend growth + Share growth
The best dividend investing strategy follows a basic 3-step process:
- Research and select dividend-paying stocks that consistently grow their dividend.
- Consistently invest in these stocks every month and ensure that they are in different industries.
- Reinvest the dividends you receive and continue to do so until you desire (e.g., when you retire).
This constant cycle of purchasing the same stocks repeatedly, and continually reinvesting the dividends you receive back into the same stock, will give you the ability to receive more dividends every time they are paid out. If you are continually reinvesting and do not withdraw the money, however tempting the unrealized gains may be, you can expect to see tremendous gains in the long-term.
To reiterate, always reinvest your dividend payouts to purchase more shares. The more shares you own, the more dividends you will receive. Furthermore, the longer you hold and reinvest into a stock that is continually increasing its dividend, the more income potential you have in the future.
The key here is to always reinvest all of your dividend payments, because if you start to withdraw the dividends for something else, the double compound effect will not take place. However, when the time is right, you can stop reinvesting the dividends you receive and cash it all out.
Put simply, you have to be patient with this strategy for it to payoff. This is a long-term investing strategy that is both proven and can bring you significant amounts of passive income in your retirement.
The sections below will now discuss how you can go about analyzing and selecting the best dividend-paying stocks.
Dividend Yield
Understanding the dividend yield is vital to your success as a dividend investor.
Dividend yield is the ratio of a company's annual dividend compared to its current share price, as shown in the formula below:
Dividend yield = Annual dividend / Current stock price
A good dividend yield is dependent on the market and the time period. For example, in the 2008-2009 stock market crash, even a 1-3% dividend yield would have been great. On the other hand, if we look at a booming economy time period, between 3-7% is a more ideal dividend yield range. Ultimately, it really depends on the market and the time period.
In general, I would recommend investing in dividend-paying companies that have a starting dividend yield of 3-5%. This varies from company to company, the current economic situation, and which industry it's in.
If you're interested, here's a list of the highest dividend stocks by yield.
One mistake many new dividend investors make is to only look at high dividend and low growth stocks. If you invest in a low growth but high yield dividend stock, the compounding effect will be slower, and you may struggle to hit your goals. In addition, higher dividend stocks are generally a lot more riskier, and therefore are a lot more likely to cut or reduce their dividend in the future.
Similarly, you want to avoid low dividend and high growth dividends. Although you do have high growth, the double compound effect will not be in full force and you will struggle to reinvest the dividends you earn. It may take a long period of time before you even have enough to reinvest the dividends you earn back into the stock. The only case where this would work is if you were to invest for 80+ years, which is unrealistic for most people and not sustainable for the high dividend growth company.
In short, a dividend-paying company with an average amount of growth and an average amount of dividend yield is ideal. Moreover, dividend yield should always be looked at with dividend growth. You cannot just look at one and ignore the other.
Dividend Growth Rate
As you should be aware of by now, the dividend growth rate is an important factor when investing in dividend-paying stocks.
One of the first things you want to do when researching a dividend-paying stock, is to analyze the company's dividend growth history. Depending on how conservative you want to be, you can look as far back into the future as you'd like. I would suggest 5-10 years, but there's nothing wrong with looking even further back and seeing how well their dividend is growing.
You can calculate the annual percentage growth of a dividend throughout looking up the dividend history for two consecutive years and then using the formula below:
Dividend growth rate = (Present dividend - past dividend) / Past dividend
If a company's dividend is growing consistently and you do see a good track record of it growing every single year, then you may want to consider investing in this company.
Ideally, you want to look for dividend-paying companies that consistently grow their dividend every year and at around the same percentage. One good example of this is the Coca-Cola Company (KO), as shown in the image below:
Something that you should be aware of, that a lot of new investors tend to ignore, is to be aware of the time period that the dividend is actually growing.
If you're looking back 5-10 years, or even 20 years in the past, be aware that there are some crashes that do come along. Therefore, if a dividend-paying company slightly lowers its dividend growth rate during an economic downturn, you can probably assume it's the economy's fault as a whole.
Again, an example of this is the 2008 recession. If you examine the stock prices of every publicly-traded company in the U.S. from 2008-2009, almost all of them decreased in stock price. If you look at their dividends, a majority of them decreased the rate at which they grew their dividends, while others eliminated dividend payments altogether.
With all of this in mind, what I would recommend is to look for a dividend growth rate of at least 4-5% (6-7% is even better if it's sustainable). This is reasonable and doable by most companies. Moreover, this rate accounts for inflation, which over the last decade has been around 2% every year. It also takes into account of any miscellaneous things that may happen, such as a bad performing year or a stock market crash.
In short, ensuring that a company has a great dividend growth rate and dividend yield will provide you with the most return over the long-term investment horizon.
Forecasting Future Dividend Growth
As an investor, you can forecast a company's future dividend growth by using data that is available to you. For example, you can take the average of the last five years of annual dividend growth for a company, and then use it to forecast next years dividend.
For example, if the average annual dividend growth over the past five years for a company is 5%, with the current dividend at $1.00 per share, and if the company's business model and growth are still strong, you can probably expect a $1.05 dividend in the following year ($1.00 × 105%).
Obviously, these forecasts are not completely accurate, as they are predicting the future. No one knows for sure how a dividend or any specific company is going to perform, but investors can do their best by using the data that is provided to them.
Dividend Aristocrats
Dividend aristocrats, among certain minimum size and liquidity requirements, are companies in the S&P 500 with 25+ consecutive years of dividend growth.
If you invest in a dividend aristocrat company, you can almost guarantee that your dividend will continue to grow, as these dividend aristocrats are among the best dividend growth stocks.
Dividend Payout Ratio
The dividend payout ratio is a crucial ratio to examine before investing in any dividend-paying company. Its formula is shown below:
Dividend payout ratio = Dividends per share / Earnings per share
To explain this ratio further, if you received $1.00 in dividends and the company's earnings per share (EPS) is $2.00 per share, then your dividend payout ratio would be 50% ($1.00 / $2.00).
A higher or even lower payout ratio is not necessarily better. You should be aiming for around 40-60%. Closer to 50% is ideal. However, you should also compare the payout ratio for your dividend-paying company to the industry average or to similar companies, as different industries have different payout ratio averages.
You may assume that a higher dividend payout ratio is better, because you'd be earning a lot of dividends per share, and would be making a lot more in dividends. However, this is not entirely true, as you need room for the dividend to grow in the future, and a high dividend payout ratio can directly restrict this growth. As a long-term investor, you want your dividends to be sustainable over a long period of time. At the same time, you want to be earning lots in dividends, so you should typically stay away from a low payout ratio.
In other words, the reason a high dividend payout ratio is bad, is because it results in low growth for the company. If a company is paying out a majority of its earnings to its shareholders as dividends, it will not have enough money left to reinvest back into the company. Over the long-term, this will not be good for the company and its investors, as it could lead to bankruptcy, lower stock prices due to stagnant growth, and of course, lower or cut-off dividends.
Furthermore, if the dividend payout ratio is too low, then as an investor, you're not getting enough reward for the money you are putting in. Is it really worth investing your money into something that will not pay you out a lot? I assume not. In this case, you can turn to many other companies that offer much higher payout ratios.
What you tend to notice with payout ratios, is that newer companies tend to have smaller payout ratios as they tend to invest a lot of their money back into their company to grow it. The opposite tends to holds true as well, with larger and more established companies offering higher payout ratios. This is because these companies have reached much of their potential, and are prioritizing their long-term sustainability over growth opportunities.
Therefore, investing in earlier-stage companies is not wise, as their history of paying out dividends is short or non-existent, so there's little certainty that they will continue to distribute and grow their dividend payments in the future. It's also not always the best choice to invest in super established companies that have little room for future growth, because this will limit the double compound effect.
In short, we want something in between, which is a growing stock that pays out high-enough dividends.
Ability to Pay Back Debt
Companies with high amounts of debt tend to perform poorly in the stock market as they aren't able to grow in a sustainable and profitable manner. Therefore, it's very important that a company is able to pay back its debts, because it can significantly limits a company's potential.
One of the first things you should ask yourself before investing in a dividend-paying company is to question whether the company can generate money without taking out debt.
Some companies have to rely on loans in order to grow their business and, as a result, do not have any extra cash on hand or positive net income which they can reinvest back into themselves to grow. However, companies that rely heavily on loans are also focused on paying back these loans, as they accumulate interest over time. Therefore, these companies will miss opportunities for growth and will not grow as much as other companies who can manage their debt.
As you may have guessed, a high amount of debt can cause a dividend to be cut. A company has the right to cut its dividend whenever it likes. Ideally, you want to look for companies that are able to generate a profit every year without taking out loans.
Debt Service Coverage Ratio
To evaluate debt, you can begin by looking for for companies that have a debt service coverage ratio (DSCR) of ideally 3:1. This formula is shown below:
Debt service coverage ratio (DSCR) = EBITDA / (Interest + Principal)
where:
- EBITDA = earnings before interest, taxes, depreciation, and amortization
Put simply, this ratio will help you evaluate how well a firm can use its operating income to pay its current debt obligations.
Net Debt-to-EBITDA Ratio
The net debt-to-EBITDA (earnings before interest, taxes and depreciation) ratio measures a company's leverage and its ability to pay back its debt. This is another ratio I would use to evaluate a company's debt management abilities.
Net debt to EBITDA = (Total debt - Cash and equivalents) / EBITDA
The lower the net debt-to-EBITDA ratio is for a company, the better, as it indicates that a company is more capable of handling and settling its debt burden. Most companies have a ratio higher than 1, with equal amounts of debt and EBITDA.
A high ratio of net debt-to-EBITDA reveals a company that is high in debt. A ratio of 4 or higher is considered to be too high. A higher ratio, and one that has been increasing over multiple periods, may indicate a dividend cut in the future.
Return on Equity
Return on equity (ROE) is a useful metric to examine to understand how efficiently capital provided by equity investors is being deployed by a particular dividend-paying company.
The formula for ROE is shown below:
Return on equity (ROE) = Net income / Shareholders' equity
In order to actually understand what return on equity (ROE) really is, it's essential to make sense of the ROE formula. If you complete this formula, you'll get a percentage, which usually ranges from 5-20% for many dividend-paying companies. The higher the number, the better. You want to make sure your shareholder's equity is actually causing the income to rise.
Ideally, you want an ROE between 10-15%, as it indicates that the company is capable of deploying the capital its shareholders' provide to generate additional returns.
If it's below 10%, you may want to have second thoughts on investing in the company and this may mean that the company is not efficiently using your money to generate more money with its investments. If you have 15-20%, this is obviously better but rather rare.
When you look at the history of the company, don't just look to see what a company's ROE was in the prior year, but look at the 5-year history. Always examine the company to determine if it's able to maintain this ideal 10-15% ROE range.
Credit Ratings
When companies are evaluated and graded based on their financial standings, this refers to credit ratings.
"Rating agencies" serve analysts and investors by evaluating companies and giving them a grade based on their financial standings. This grade helps investors determine whether to invest in a specific company or not.
In specific, this grade helps investors determine how risky an investment is. Therefore, if you are a more risk-prone investor you would not require a high rating, whereas if you're a risk-averse investor, you would prioritize investing in “A-rated” companies. This is because higher rated companies are less likely to crash or lose substantial stock value.
Although these rating agencies full time job is to evaluate companies and determine how risky the investment is, it’s not always fool-proof. Therefore, if a company has an A+ rating, it’s not impossible to lose money in that specific investment (over the long-run), although it’s unlikely that you will.
Rating agencies evaluate these companies based on grades. With the highest rating being an A+ and the lowest being a D. A “D rating” for a company does not necessarily mean that it’s extremely risky. It more so suggests that you should completely avoid investing in the company. It does not mean high risk, high reward.
Ratings therefore provide a picture on a company’s financial standing and its ability to pay off debt that has accumulated over the years. It also predicts the possibilities of a stocks price to increase over the following years.
For dividend-paying stocks, I would suggest investing in companies that only have a “B+” or better rating. Don’t settle for anything below a B+, as there are plenty of great companies out there that are rated higher than a B+. Again, don’t completely depend on these ratings, and use them more as guidelines in your dividend investment research process.
The most popular rating agencies are Standard & Poor’s, Moody’s, Fitch, and Morningstar (DBRS). Their rating systems are shown in the table below:
How to Find Credit Ratings
Finding free credit ratings for companies can be difficult. However, for larger companies, and for all of the companies featured on the dividend aristocrat list, credit ratings are easier to locate.
Here are three different methods (among many others) you can use to find credit ratings for large publicly traded companies:
- Look through annual reports (10-K’s) for companies on their “Investors Relations” section of their website.
- Simply Google: “company name + credit ratings”
- Register an account with Standard & Poor’s (for free). Afterwards, you can search and find credit ratings for certain companies.
Number of Dividend-Paying Stocks to Own
If you're a new investor you should invest in fewer than ten dividend-paying stocks. Unless you've been in the stock market for 2-3 years or more, sticking to fewer ten five dividend stocks is typically a safe and smart decision.
This allows you to keep track on what is going with each stock and makes it manageable for the average investor. If you have more than ten dividend stocks, it will be difficult for you to keep track of all of them, determine whether to buy more, or even sell in some cases. If you invest in fewer than ten dividend stocks, it allows you to invest in only the best dividend-paying stocks. If you're looking to invest $25,000 between tens stocks, for example, this can be done easily with ~$2,500 in each.
Once you start dividing this $25,000 into dozens of stocks, however, you may begin to notice that not all of your investments are ideal. Although your portfolio will be diversified, which is of course great, the quality of the stocks that you are putting your money into will likely decrease as you've already found the best stocks.
As you look to diversify your portfolio and purchase more stocks, you may find your expectations for stocks to decrease, as it will become harder and harder to find stocks that are just as good as your primary five or ten dividend stocks. So, in short, why invest in lower quality stocks and give yourself a harder time when you can invest in a select few that you really understand?
The Bottom Line
This beginner's guide to dividend investing should have provided you with a broad understanding on how to invest in dividend stocks for income.
The next step is to begin researching dividend-paying companies, applying the concepts taught here, and to purchase dividend-paying companies you think are valued at a good price.
Afterwards, continue to reinvest the dividends you receive until you reach a point where you are comfortable with the cash flow coming in. Ultimately, the end goal is to receive enough in dividends to retire early and/or have as a stable passive income source.