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Dividend Investing is a popular and highly effective stock investing strategy, and yet many beginning investors do not truly grasp the concept of investing in dividend stocks; in fact, many do not understand what a dividend is and how it works in relation to an investment.

In this guide, we will discuss all you need to know about dividend investing and especially how to invest successfully in dividend stocks. By the end of this guide, you will have learned about:

• What is a dividend, and what is its role in stock investing?
• The concept of dividend stocks
• Dividend yields and how to assess dividend stocks
• Potential risks to dividend investing and how to tackle them
• How are dividends taxed?
• Effective dividend investment strategies you can try

Let's begin this guide from the basics.

What Are Dividends?

A dividend, or to be exact, a dividend payment, is the distribution of a company's earnings to its shareholders. We can think of dividends as a reward paid to the shareholders for their investment in a company's stock.

Dividend payments are typically paid out of the company's net profits. In most companies, the majority of the profits are kept within the company as retained earnings (which will be used to fund the company's business activities), but some can be allocated as dividend payments.

Ideally, a company will pay dividends when it is adequately profitable, but in some cases, companies may still make their dividend payments even when they don't make adequate profits to keep their reputation in making regular dividend payments.

In most cases, dividends are paid in cash, but dividend payments can also be issued as shares of stock or other forms.

Stocks of a company that issues dividends are called dividend stocks, but other than companies, mutual funds and ETFs (Exchange Traded Funds) can also pay dividends.

How often are dividends paid on stocks?

Dividend payments can be paid annually, quarterly, monthly, or other time periods. However, the vast majority of U.S. companies with dividend stocks issue quarterly dividend payments.

How Dividend Stocks Work

Now that we've understood the basic concept of a dividend, how does a dividend stock work?

Let's use an example to explain the concept of how a company pays dividends to its stockholders.

Let's say company X issued shares of stock worth $20 now, and each share earns a dividend of $0.20 quarterly.

An investor buys 100 shares of company X's stock (for $2,000), so over the course of a year, this investor would receive $80 in dividend payments ($20 each quarter). In this case, company X's stock produces a dividend yield of 4% (each dollar invested in its stock would yield $0.04.) We will learn more about dividend yields and how much of a dividend yield is considered good or bad later on in this guide.

Once an investor has received a dividend payment, they can either spend the money (including for buying stocks in a different company), reinvest the money to buy more shares of company X, or simply save the cash.

Dividend's Role in Stock Investing

A key perk of investing in dividend stocks is that the investor would receive dividend payments regardless of whether the company's stock price goes up or down (as long as the company continues to make dividend payments).

This means that by investing in dividend stocks, you'll introduce predictability to your portfolio.

Not every company that regularly disburses dividend payments will be able to maintain their dividend payout regardless of their profits and economic situations. Having a diversified portfolio of dividend stocks can minimize your risks and produce reliable income, regardless of the economic environment.

When managed properly, earnings from dividends can contribute to your total investment returns and allow your portfolio to perform better than the market.

How Investors Can Collect dividends

As mentioned, many companies (especially U.S.-based companies) usually pay their dividends quarterly.

The company's board of directors will make its decisions regarding the dividend payment schedule and other dividend policies. The decision will then be relayed to investors/stockholders through an SEC filing or a press release.

For dividend stocks, investors must pay attention to some key dates:

1. Dividend announcement date: the day the company's board of directors announces its dividend plans. The stock's price may be significantly affected after this announcement.
2. Record date: the deadline to purchase the stock. Only investors who are recorded as shareholders as of this day are eligible to receive dividend payments.
3. Ex-dividend date: shareholders purchasing the stock as of this date will not receive the next dividend payment. Typically, the stock's price will go down on this date.
4. Payment date: the day dividend payment is made.

Dividend Investing: Terms and Metrics You Need to Know

Before investing in dividend stocks, it's important to understand the following terms and metrics so you understand how to evaluate the potential performance of each stock.

1. Dividend Yield

The dividend yield, also called the dividend-price ratio, is a key metric in dividend investing and refers to the amount of dividend paid per share annually divided by price per share (in percentage).

If a company pays $1 in dividends per year while the stock costs $30 per share, then the dividend yield is 3.33%. The higher the dividend yield, the 'better' the stock is when it comes to dividend investing. However, we must also pay attention to other metrics when evaluating the stock, like whether the high dividend payout is sustainable or, even better, gradually increasing year by year.

Keep in mind, too, that a high dividend yield may also be suspicious, and you'll need to evaluate other factors.

2. Dividend Aristocrats

The term 'dividend aristocrats' refers to a group of companies that are:

• Members of the S&P 500
• Must have successfully increased the annual dividend per share for at least 25 straight years
• Must have an average daily trading amount of at least $5 million
• Must have a float-adjusted market capitalization of at least $3 billion

Investors can purchase the S&P 500 Dividend Aristocrats ETF (NOBL) to easily purchase dividend aristocrats companies and add a reliable source of income to their portfolio.

As of March 2022, there are 65 dividend aristocrat companies, including well-known companies like IBM, Walmart, and others.

3. Dividend Payout Ratio

Not to be confused with the 'cash dividend payout ratio,' which we will discuss later, the dividend payout ratio is the dividend divided by the company's earnings per share (on percentage).

If, for example, a company has a net income earning of $2 per share and pays $1 in dividends per share, then the company has a dividend payout ratio of 50%.

The lower the dividend payout ratio, the more likely the company can maintain the regular dividend payment and vice versa.

4. Cash Dividend Payout Ratio

The ratio between the dividend payment and the company's free cash flow (total operating cash flows minus capital expenditures).

Various non-cash expenses can cause a company's earnings to vary from time to time, so this metric should be compared to the standard dividend payout ratio to more accurately evaluate the dividend payment's sustainability.

5. Earnings Per Share (EPS)

The EPS metric is used to normalize the company's earnings to its per-share value.

For example, if the company has $1 million in net earnings, and has 1 million shares currently being published, then this company's EPS is $1.

Companies that can regularly and sustainably increase their EPS over time (and effectively raise their dividend payments) are considered healthy. Evaluation of a company's EPS growth is arguably the most important thing you should do when considering different dividend stocks.

6. Price-to-Earnings Ratio

Price-to-earnings ratio, or P/E ratio, is the ratio between the company's share price with earnings per share (EPS).

If the company's stock is currently priced at $10 and has an EPS of $1, then the company has a P/E ratio of 10.

P/E ratio is useful when evaluating whether a stock's price is currently fairly valued.

7. Total Return

The total sum between the amount of dividends paid and capital gains (increase in stock price).

If, for example, an investor purchased a stock at $10 per share and got $1 in dividend in a year while the stock's price also increased to $12 in the same period, then the investor got $3 in total return or 30%.

Evaluating Dividend Stocks

Arguably, the dividend yield is the most important metric to consider when evaluating dividend stocks, but it's a common mistake for beginning investors to simply buy stocks with the highest dividend yields without factoring in other important metrics.

It's important to understand that a high dividend yield is not everything, and in fact high yields can be caused by a decrease in stock price due to the risk of a lower dividend payment, a phenomenon we call the "dividend yield trap."

It's crucial to carefully evaluate a dividend stock beyond simply looking at dividend yield, and here are some important considerations you should have:

• If a stock has a significantly higher dividend yield than similar companies, it can be a major red flag.
• Study the company's balance sheet: cash, debt, asset/liability ratio, and evaluate whether the current dividend yield aligns well with the company’s financial situation.
• Evaluate the company's dividend history, especially year-by-year dividend yield and payout growth, to measure sustainability.
• Use the payout ratio metrics we have discussed above to further measure the dividend's sustainability.

Again, remember that a high dividend yield doesn't always tell the whole story. It's typically better to buy a stock with a lower dividend yield but with solid fundamentals rather than a high-yield stock with sub-par performances on other important metrics.

It's often more profitable to focus on dividend growth rather than dividend yield alone.

Investing in Dividend Stocks: Your Options

There are three basic options for investors looking to invest in dividend stocks:

1. Individual company stocks

Pretty self-explanatory, investors can simply purchase stock in a company that pays dividends. With this approach, the investor will have the most freedom in choosing the stocks in which they would like to invest. At the same time, the investor should first perform a thorough evaluation of each stock while considering the metrics we've discussed above (and more.) Maintaining a diversified portfolio can be challenging in the long run.

2. Mutual funds and ETFs

For investors who are looking for an easier approach to building a diversified portfolio, then investing in ETFs and funds with high dividend yields can be a viable option.

Dividend Investing Strategy: Best Practices

In dividend investing, there are actually relatively few strategies to consider.

The basic principle in developing a dividend investing strategy is about minimizing the risk of a dividend cut.

It's important to always remember that it is not the obligation of any company to pay its dividend, unlike paying interest on debts. When the company's profitability is at risk, for example, it's possible for the board of directors to announce a dividend cut.

This is why it's crucial to carefully evaluate the company's ability to regularly and consistently increase its dividend (dividend growth) rather than simply evaluating yield.

In this section, we will discuss five important best practices to maintain when developing a dividend investing strategy:

1. Evaluate the business's underlying performance

In dividend investing, it's important not to solely focus on dividend-related metrics but rather to evaluate the company's performance as a whole.

Remember that by purchasing the company's stock, you effectively become its owner, and so you should evaluate the company's performance as an owner, including but not limited to:

• Analyze the company's financial statements. Assess how much revenue and profit it made last year, how much debt it has, and what its cash flow looks like.
• What is the company's business strategy, and how is the company currently executing this strategy?
• How are the company's direct and indirect competitors performing?
• How much the company is retaining its profits.
• The overall situation of the company's industry today and in the short-term/long-term future.
• Analyze relevant metrics to evaluate the company's capabilities in generating future profits and dividends.

By carefully analyzing the company's performance rather than focusing on share prices and dividend payments-related metrics, you can be more objective in evaluating a stock's worth and avoid the yield trap.

2. Determine the stock's fair value

One of the keys to successful stock investing (not just dividend investing) is to make sure you are buying the stock at a fair value, so it's crucial to have a good idea of what the business is currently worth.

How do we determine a business's value? While we can evaluate many different factors, the most important thing is to assess the business's ability to return the shareholder's investment.

Meaning, one of the best ways to assess a stock's value is to evaluate its future dividends potential. Long story short: measuring the fair value of the business is about estimating the sum of its future dividends, even decades in the future.

To do so, there are three main metrics we'll need to factor in:

Dividend Size

For example, let's say we are comparing two stocks: one from company X and another from company Y.

Company X pays $100 in dividends per year in a ten-year period ($1,000 in total), while company X only pays $500 over ten years.

Which of these two companies is more valuable? Obviously, company X, with its larger dividend payment.

The larger the dividend size, the higher the fair value of the business, although you'll still need to pay attention to the two other metrics.

Timing of dividend payouts

Let's say company A pays $100 in dividends this year, and company B pays $100 in dividends, but you have to wait five years.

It's always better to receive dividends early since the longer you have to wait for a dividend payment, the less present value it will be. So, the earlier a company pays its dividends (and more frequently, if possible), the higher the fair value.

Regularity of dividend payments

For example, in a 10-year period, company X pays dividends five times, or 50%, while company Y pays dividends seven times in 10 years.

In this case, company Y has a higher fair value since you have a higher (70%) chance of getting dividends each year, while with company X, we might get dividends paid only 50% of the time.

The higher the regularity and certainty of dividend payments, the higher the business's fair value is.

3. Use value investing considerations

While there are some core differences between dividend investing and value investing, it's crucial to also use main value investing principles when choosing your dividend stocks, especially to ensure there's a significant margin of safety, the gap between the current price and the stock's fair value.

Use value investing principles to determine whether the current share price is low, high, or fair. Ideally, you'd want to purchase a stock when it's priced below its fair value (low), but at the very least, make sure not to buy when the price is high.

Why is this important in dividend investing if we are going to focus on dividend payments as a source of earning?

Imagine the following scenarios. Let's assume we are going to buy stock from a company that will always pay $100 in annual dividend in an unlimited time period.

• If you buy the company at $1,000 per share, then you'll get 10% in dividend income. This is considered excellent.
• If you buy the stock at $2,000, then you'll get 5% in dividend income. Not bad, but not as good as 10%.
• If you buy the stock at $5,000 per share, then you'll only get 2% in dividend income.

As we can see, the gap between the purchase price and the fair value (margin of safety) will ultimately determine the ROI of your investment.

However, keep in mind that you can only estimate fair value, and you won't be able to get a 100% accurate assessment. It's important to keep your estimate realistic, or else you may miscalculate the actual margin of safety.

4. Diversify your portfolio

In investing, the idea behind diversification is fairly simple: don't put your eggs in one basket.

If, for example, you put 100% of your money in a single company and the said company goes bust, then you'll lose all your money. However, if you put 10% to 10 different companies, then if one company goes bust, you'll only need the rest of your investments to grow by 10% to cover the losses.

Creating a diversified portfolio is ultimately about reducing your exposure to various risks, and you should diversify based on three layers:

1. Diversify across companies

For example, you may decide that owning one meat supplier company is too risky, so you buy ten different meat suppliers, all are U.S. based.

This approach will protect you from cases like when one meat supplier went bankrupt, so you'll only lose 1/10th of your total portfolio. However, keep in mind that if there's a situation that affects the whole meat supplier industry, then diversifying across multiple companies won't protect your portfolio.

2. Diversify across industries

Instead of owning ten meat suppliers, you'll better manage your risks if you spread your investments across different industries (i.e., restaurants, technology companies, etc.)

3. Diversify across locations

To further reduce your exposure to risks, you may also want to diversify across different geographical locations. Nowadays, building a portfolio that's diversified across different geographical locations is fairly easy, so this should be an option you should consider.

Wrapping Up

Accurately identifying investment opportunities in dividend stocks can be easier said than done, or else everyone would be doing it right away. This is why it's very important to learn from the best and improve your knowledge first.

Looking to learn more about making money from stocks? Here at Briefing.com, there are more than enough lessons to get you started and help you learn at your own pace.