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.


What is Dividend Investing?

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.


Why do Companies Pay out Dividends?

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.

  • First of all, some companies believe that offering a dividend is irrelevant to many investors, since those looking for a reliable income vehicle for their portfolios will often turn to bonds for their regular and stable interest payments. Stock dividend amounts can fluctuate, and while decreasing or cutting out a dividend is the last thing any company would choose to do, because of the potentially negative repercussions on its stock price, it can happen; especially when business earnings or the economy in general take a turn for the worse.
  • Secondly, those companies that forgo dividends understand that they are taxed more heavily in the hands of the investor than long-term capital gains. Rather than paying out excess earnings directly to investors, some companies prefer to increase the value of both their business and their stock price by reinvesting those funds back into their own growth. This strategy can help to support such valuable activities as opening new branches or departments, purchasing additional assets or companies, and implementing better marketing initiatives.

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.


How to be Eligible for Receiving Dividends – Considering the Ex-Dividend Dates

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.


How to Find the Best Dividend Stocks

Step 1: Looking for Stocks that Pay Dividends

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.


Step 2: Looking for Financially Strong Businesses

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.


Step 3: Considering a Business’s Future Prospects

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.


How to Build a Diversified Portfolio

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.


A Final Word

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.

About the Author

Wealthy Education

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