It can be difficult to know just how to get into stocks if you have no prior experience with the stock market.
Fortunately, dividend investing is not only a relatively straightforward method for getting your feet wet in the market, it can also be a very effective way to introduce passive income into your investment portfolio.
When you buy shares of stock in a dividend-paying company, you become entitled to receive cash payouts several times a year that are based on the profits generated by that company.
And if that same business continues to perform well, and experiences positive financial growth, the amount paid out in dividends often increases alongside company earnings.
In order to understand how to invest in dividend-paying stocks for your best chance of success, you should have a thorough understanding of exactly what a dividend is, why companies pay them to their shareholders, and how you can make the most of them to build a solid and diversified investment portfolio.
The focus of dividend investing is to generate both passive income and a positive cash flow within your portfolio, from stock dividends.
In its simplest form, a stock dividend is an amount of money, usually in the form of cash, which a company pays out at regular intervals to those investors who hold shares of its stock.
When you buy shares in a dividend-paying company, you are effectively buying a very tiny fraction of ownership in that company, and as a partial owner you are entitled to share in any profits.
Many companies issue lump sum payments on a quarterly basis, or every three months, and when a business produces strong and stable earnings over the long-term its dividends not only remain consistent, but often benefit from regular increases as well.
But how can you know if a company’s annual dividend amount makes it worth considering as a potential investment?
Payouts fluctuate from business to business, so what size of a dividend should be considered attractive?
Just because two different companies both pay out dividends of $1 per share every year, it doesn’t make them equitable in terms of potential investments. You need to know how much you will be earning from each dollar you invest in a company’s shares, and the best way to discover that is to consider the stock’s dividend yield.
The dividend yield is simply an amount, represented as a percentage, which indicates your return on investment (ROI) in much the same way that a bank account paying you 2% interest, equates to earning an ROI of 2 cents for every $1 you keep in the bank.
If Company A pays $1 per share each year to its shareholders, and its shares cost $20 each to purchase, you would benefit from an annual dividend yield of 5%.[alert-success]$1 / $20 = 0.05 = 5%[/alert-success]
If, on the other hand, Company B also pays $1 per share every year, but its shares cost $40 each, the dividend yield would be far less at only 2.5%.[alert-success]$1 / $40 = 0.025 = 2.5%[/alert-success]
Therefore, all else being equal, to earn the highest level of income possible from dividend investing, you should make a habit of looking for those companies that offer the highest dividend yields.
But why do companies pay out dividends in the first place?
Not all companies offer stock shares that entitle the owners to regular dividend payouts, so it’s obviously not mandatory for every business with public shares to do so.
Stocks that pay dividends are meant to serve as a signal to potential investors that a company is financially strong and stable, and that it expects to remain so over the long-term.
Essentially, dividends are a real-life indicator of a company’s financial health, and they indicate that the business is confident in its ability to perform well consistently enough to earn a regular profit.
Many people like you who are looking to generate passive income through the stock market, will choose dividend-paying stocks over other types for this very reason, so it’s a great way for a mature and stable company to attract new investors and sell more shares.
After all, it’s partially through investor dollars that a business continues to fund its operations and growth activities. And there’s the added benefit for a dividend-paying company that any increases it can make to its dividends will lead to a correlating increase in its stock price, and to its overall value in the eyes of potential investors.
So why doesn’t every company offer a dividend to its shareholders?
There are two main reasons why a business may choose to forgo offering a dividend payout on its shares.
But for our purposes in exploring the great potential offered by dividend investing, we will only consider stocks that pay dividends.
Just the same, it’s important to be aware that not all dividend-paying stocks are created equal, and that not all of them are good candidates for helping to earn passive income.
Later, we will explore how to pick the most profitable dividend stocks to invest in for this purpose.
Because a company sets up regular payout dates for its dividends each year, it’s crucial that you understand the various dates associated with dividend investing in order to avoid buying a stock at the wrong time, and missing out on the dividends you were expecting to receive.
The key dates associated with every dividend include the Record Date, the Ex-Dividend Date, and the Payment Date.
While the payment date is straightforward in its definition as the date on which dividend payments are made to eligible shareholders, it’s the relationship between the other two dates that determines exactly who is an eligible shareholder, and who is not.
When a company declares (on the Declaration Date) that it will be paying a dividend to eligible shareholders, it also reports the record date associated with that dividend.
The record date is the cut-off date by which an investor must be on record as owning shares of the company in question, in order to be eligible to receive the latest dividend. To accomplish this, it means the investor must own or have purchased shares before the ex-dividend date, which is set at two business days prior to the record date. This time difference has been established to correspond with the time it typically takes in North American markets for a trade to settle, and for investors to be on record as shareholders after a stock purchase.
Shares bought or sold before their established ex-dividend date are bought and sold with the attached right to receive payment for the most recent dividend amount. Those purchased or sold on or after the ex-dividend date do not have this right attached to them, and so are described as being “without (or “ex”) dividend”.
In summary, you must own shares of a given stock before its ex-dividend date in order to receive the next dividend that’s been scheduled to be paid to shareholders, and there are two ways you can do this.
You can either purchase or hold company shares before the ex-dividend date, or you can sell shares you already own on or after this date.
In either case, you will be eligible to receive the dividend in question, since you will be the shareholder of record on the stock’s established record date.
Dividend investing for the purpose of building a passive income stream is really only effective when you look for stocks that pay out regular dividends to shareholders.
At the same time however, companies that pay out too large a portion of their earnings as dividends run the risk of coming up short in terms of having the available resources to fund their future growth. And it’s a company’s continued growth that provides the basis for regular dividend increases.
Ideally, you should look for those businesses that retain a minimum of 40% of their annual earnings to reinvest in their own development, and as an investor, this means seeking out those stocks with a dividend payout ratio of 60% or less.
Companies that are mature, stable and financially strong provide the best chance that an investor will continue to receive consistent dividends that offer good potential for increases.
As such, you should only consider solid businesses that have a history of strong financial performance, and that have demonstrated consistent growth in both their net income, and their cash flow.
In practical terms, this means looking for low-debt businesses with a debt-to-equity ratio of less than 50%, since the more debt a company carries in relation to its assets, the more income it must put toward supporting that debt, and the higher the risk that this liability will begin to cut into its dividends should earnings drop off for any reason.
Beyond just maintaining dividend payouts, companies selected for passive income investment purposes should ideally be striving to increase those payout amounts, on a regular basis, through earnings growth.
This means you should look out for those businesses that have a selling advantage over their competitors, or which offer a product or service that will remain in high demand over the long-term, or that demonstrate strong management performance.
Any of these attributes can contribute to a company’s successful future growth, and the details surrounding its management policies and expansion strategies can be found in every business’s annual report.
Dividend investing can provide a good source of passive income, but it’s not necessarily the fastest way to grow your money over the long-term.
There are other investment vehicles that can help you to grow your profits at a faster rate, and you should consider investing in a variety of investment types in order to take advantage of their various benefits.
Diversification within your portfolio remains one of the keys to investment success because it can help you to both dilute risks and to maximize returns.
Rather than investing all of your money in dividend-paying stocks, you would do well to also include investments such as Exchange Traded Funds (ETFs) and value stocks in your portfolio.
While income stocks will help you to create a good stream of passive income, ETFs can contribute to the long-term stability of your overall portfolio returns, and value stocks may help to increase those returns at a faster rate.
Dividend investing is by far one of the best ways to use the stock market to generate passive income and to increase cash flow in your investment portfolio.
Remember that not every dividend-paying stock is useful for this purpose, and you must learn to identify the profitable ones in order to continue to build your wealth.
Before you purchase any investment, you should take the time to become familiar with exactly how it works, and its inherent risks and possible disadvantages.
If you learn as much as you can about the dividend investing approach before you buy your first stock, you will greatly increase your chances of benefitting from regular, long-term passive income, with as little risk as possible.
Dividend-paying companies distribute a portion of their net income to holders of their stock each year, and reinvest any remaining profits back into their business.
Because these dividend stocks make regular cash payments to their shareholders, they can be a great way to introduce the element of passive income into your investment portfolio.
Dividend stocks also offer a number of benefits that go beyond the allure of passive income, but as with every investment, both the advantages and disadvantages of dividend investing should be examined before buying in.
Most investors like dividend stocks because of the fact that they can provide a steady source of income with little or no work, much like interest from a bank account but with a greater potential for return on investment.
Although expecting dividend-paying companies to continue to make good on their dividend payouts may sound a little risky, the fact is that mature, well-established companies will go to great lengths to not only keep their dividends consistent and predictable, but to increase the amounts paid out on a regular basis.
Stable dividends are one of the most important factors in a company’s ability to keep its stock price strong, and dividend-paying companies make it a priority to do whatever is necessary to maintain a healthy financial position.
Compounding is a powerful way to increase your income by using earnings to generate even more earnings.
Through compounding, you can earn more income without having to invest any additional money of your own, simply by letting your earnings go to work for you.
In the case of dividend investing, when you use your dividend earnings to purchase additional shares of company stock, you’ll earn more money because every share you purchase earns its own regular dividend payout.
This compounding strategy benefits from the power of exponential growth: your original investment generates a certain return that can be reinvested to produce greater returns, and those returns can be reinvested, and so on.
The longer you continue to reinvest, the more quickly your returns will grow.
When you invest in dividend stocks, you stand to profit in more ways than one.
We already understand the potential for regular payouts offered by dividend investing, but there is also a return on investment when your share prices increase.
Non-dividend-paying stocks only offer a potential for profit when you buy their shares at a low price, and sell them for a higher one.
Dividend stocks, on the other hand, allow you to share in company profits while also retaining ownership of your investment. And since a large number of dividend-paying companies are financially stable and relatively reliable, their stock prices tend to increase over time, as their perceived investor value continues to grow.
We know that reinvesting dividend earnings is an effective way to take advantage of the power of compounding, but it can become even easier and more convenient when you use a DRIP, or dividend reinvestment plan.
As a program that allows investors to automatically reinvest their cash dividends back into additional company shares, DRIPs combine the advantages of both compounding and dollar-cost averaging.
These automatic share purchases generally occur on a company’s dividend payment dates, and may be managed by the stock company itself, or by an outside agent or brokerage.
One of the best features of many DRIPs is that they allow you to buy additional company shares commission-free, or at a discount.
One of the main drawbacks of dividend investing is that your dividend payments are effectively subject to being taxed twice.
The first instance of taxation occurs before you receive your dividends, because the corporation issuing them from its net income has to pay tax on its annual earnings, and it’s those earnings that generate the company’s dividend payments.
The second taxation occurs when you, as the investor, must pay personal income tax on any dividends you earn over the course of a given tax year.
In essence, this double taxation means you are paying tax both as a partial company owner, and as an individual.
A company’s plan for determining its dividend amounts, and any potential increases based on future earnings, is known as its dividend policy.
When a dividend-paying company makes changes to its policy, particularly those that lead to cutting or eliminating payouts, it will have a negative effect on the company’s stock price.
A stock market theory known as the clientele effect surmises that a stock’s price is strongly linked to investor reactions to company policy changes, so that when those changes occur, many investors will buy or sell their company shares accordingly.
If a company is forced to cut its dividends for any reason, you run the risk of not only losing your regular share income but also your accumulated share appreciation, as other investors sell and move on to other stocks.
Investing in companies with a high dividend payout ratio involves a certain amount of risk.
The dividend payout ratio of a company’s stock reflects how much of its earnings are being paid out to shareholders versus how much is being kept to pay down debt, reinvest in growth, or to serve as a cash reserve.
Determining the amount to pay out to shareholders can be a delicate balancing act for many companies, since they want to attract and keep investors with high payouts, but retain enough of their earnings to support future expansion, and their ability to raise dividend amounts, at the same time.
The fact is, when a company’s dividend payout ratio becomes too high to be sustainable, it can often lead to the business having to cut or eliminate its dividends altogether.
Dividend stocks tend to be less risky than non-dividend stocks overall, but in order to make the most of everything they have to offer, you should become familiar with both the pros and cons of dividend investing before attempting to put them to work as part of your investment portfolio strategy.
If you’re in the process of learning how to invest in dividend stocks, to make the most of their passive income potential, it’s crucial that you become familiar with the five key dividend dates associated with stocks that pay dividends.
Ultimately, it’s these dates that determine which shareholders will, and will not, be eligible to receive a declared dividend.
The Declaration Date is the date on which a dividend-paying company announces the next dividend to be paid out to shareholders.
Typically, this legally binding declaration describes the amount of the dividend, the date on which it’s to be paid (the Payment Date), and the dividend’s Date of Record (see description below), which lets investors know the deadline for buying or selling shares in order to be eligible to receive the dividend payment.
The Settlement Date for a stock trade is also called its closing date, and it’s the date on which the sale or purchase of a security is finalized.
A typical trade takes 2-3 business days to complete, and once the transaction has been finalized, it means the buyer becomes the new official owner of record for that security, and the seller gets paid.
In terms of dividend-paying stocks, the Settlement Date becomes important when trades are conducted just prior to a stock’s Date of Record, since it’s only the owner of record who will be entitled to receive the most recent dividend declared for that stock.
The Date of Record is the cut-off date on which you must officially own a particular stock in order to receive its most recently declared dividend.
This means you can either buy and settle, or simply hold onto, eligible shares of a dividend stock by the Record Date, and you will be entitled to receive its declared dividend.
Similarly, if you sell shares of an eligible stock before the Record Date, you will remain the official owner of those shares, and will still receive the relevant dividend, as long as the sale of those shares does not settle before the Date of Record.
The Ex-Dividend Date is the most important of all the dividend stock dates.
Ex-dividend means “without dividend”, and the Ex-Dividend Date is effectively the deadline for buying shares with the attached entitlement of receiving the most recently declared dividend.
A stock’s Ex-Dividend Date is generally set 2-3 days prior to its Record Date, in order to allow time for any associated trades to settle.
This means that as long as you buy your shares before the Ex-Dividend Date, your trade will settle by the Record Date, and you will receive any attached dividend; if you buy them on or after the Ex-Dividend Date however, you will not qualify, and their seller will receive the dividend.
Conversely, if you sell your eligible stock either on or after the Ex-Dividend Date, you will remain entitled to receive its current dividend. But if you sell your shares before this date, that entitlement is sold along with them, and the buyer will receive the dividend.
The Payment Date for a given stock dividend is also known as its distribution date, and is simply the date on which all dividend payouts are transferred to those investors who were on record with the company as official shareholders on the Date of Record.
Most companies pay out dividends on a quarterly basis.
Shares of dividend stocks change ownership frequently, as they are bought and sold throughout the trading day, so it’s important that companies set up official dates and deadlines to determine who is legally eligible to receive their associated dividend payments.
You should become thoroughly familiar with the significance of the various dividend dates, in order to maximize your investment returns.
In order to be eligible for receiving dividend payout, just make sure that you make an investment before the ex-dividend date.
Many investors are tempted to ignore companies that pay dividends when investing in the stock market, simply because the idea of earning pennies per share four times a year doesn’t seem like an investment vehicle that’s worth getting very excited about.
But this is misguided thinking…
The truth of the matter is that learning how to invest in dividend stocks effectively can play a significant role in expanding your wealth through a stream of passive income that holds real potential for steady and exponential growth over the long-term.
The most fundamental benefit of dividend investing is the ability to earn money with very little ongoing work.
Once you’ve done the initial research and analysis that’s required to identify the best companies to buy shares in, it becomes a matter of simply keeping an eye on those companies, to ensure the stocks you own remain profitable.
The beauty of dividends is that they are paid out regularly, regardless of how the stock market performs on a day-to-day basis. Dividends are not dependent on market activity, but rather on the overall performance of the company paying them out.
As long as you look for mature, financially experienced, and growing businesses to invest in, your steady flow of dividend income should continue uninterrupted for as long as you own your shares. And the return on investment you can expect for most dividends will easily beat anything you might expect to earn by keeping your money in the bank.
When your portfolio generates passive income, it allows you to spend more time on other endeavors while your money goes to work for you.
In this way, passive income through dividend investing represents the true key to financial independence.
Examining dividends offers an effective way to determine which company stocks are the most valuable in terms of their long-term income potential.
In fact, evaluating a business based on its dividend history, and its potential for future earnings, is often a far more reliable method for discovering the truth behind the numbers, than perusing a company’s financial statements.
The use of creative accounting practices means that business financial statements can, and sometimes do, get presented in ways that make a company’s profits appear healthier than they are.
Whether it’s reporting the sale of an asset as regular business income, or “hiding” a liability in layers of amortization, the better a company’s earnings picture looks in a given year, the stronger the support for its stock price will be, and the more its shares will appeal to investors.
Stock dividends, on the other hand, never hide the truth.
A company’s dividend payments will always give an accurate picture of its financial status, regardless of what may be printed in its earnings reports, simply because it takes real earnings to fund those payments.
Dividends are not just payments on paper, they are actual cash payouts made to shareholders on a regular basis, and they require a strong earnings profile to support them.
If dividend investing is a game of show and tell, you should always consider what a company’s dividends show you, rather than just relying on what its financial reports may tell you.
Dividend stocks allow you to purchase shares in financially sound businesses that share the profits from their annual earnings with their stockholders, in the form of regularly increasing dividend payments.
Dividends have a tendency to grow over time when you buy shares in solid, mature and proven companies because these businesses work hard to constantly grow their earnings, and to reward their investors with increasing dividend amounts.
Growing dividends provide the framework for an increasing dividend yield, since the higher the payout gets, the greater the return on your investment becomes.
For example, if you originally buy shares of a stock for $100 with an annual dividend of $2, and that dividend increases over time to $4, your dividend yield will have grown from 2% to 4%.
But dividend investing rewards you in another way as well.
While you enjoy your steadily growing flow of passive income from the stock you own, the value of that stock is very likely growing as well.
The capital gains resulting from this type of share appreciation is particularly common with dividend-paying companies that are financially strong and that have a unique market edge, a high performance financial strategy, or a seasoned management team.
And with dividend stocks, even if share prices do drop, dividends continue to be paid, and their yield only increases as a result.
One of the wonderful features of dividend investing is that it conveniently lends itself to reinvesting your earnings in order to generate even greater returns.
This is known as the power of compounding, since the more shares of a company you purchase, the more dividends you will earn, and the more of those earnings you reinvest in additional shares, the higher your returns will grow as a result.
In this way, dividend reinvestment can lead to exponential growth that requires no additional investment of new capital. And if you take advantage of an automatic Dividend Reinvestment Plan (DRIP), it can all happen with no effort whatsoever on your part.
DRIPs are the best way to benefit from the frequent reinvesting that leads to higher returns.
These programs are often offered by the dividend-paying company itself, in order to allow shareholders to automatically purchase additional shares of stock on each dividend payment date.
Instead of receiving your dividend in cash, the issuing company, or an outside brokerage firm or agent, will take that cash and buy more shares on your behalf. And in many cases, these shares can be purchased without incurring a commission charge.
From the steady flow of passive income, to the continued growth and reinvestment potential of dividends, to the thrill of experiencing capital gains when stock prices rise, dividend investing has a lot to offer.
While the stock market never comes with a guarantee, and you should always take the time to familiarize yourself with potential risks, buying dividend stocks can serve as an integral part of your overall ability to build long-term wealth into your investment portfolio.