I love dividends and I cannot lie. They give you the best of both worlds: playing the stock market whilst also receiving a passive income stream.
In many parts of the world, those dividends that you receive also get treated kindly by the taxman, which increases their effective return dramatically. In the U.S. and Canada you pay roughly half as much Federal tax on dividend income as you would regular income.
But dividend stocks are a mystery to a lot of people. I’m going to do my best to demystify things a little bit and hopefully inspire you to check out this great investment option. As always, if you’re unsure of what you’re doing, consult a professional. And I’m not liable for your losses.
As always, don’t forget that you can use your side gig or hustle to fund your dividend investment and achieve retirement or financial independence earlier.
What is a dividend stock?
A regular stock is a share of a company. You [hopefully] benefit from the appreciation of this share, which in turn is based on the company’s performance. The idea of “buy low, sell high” applies here.
A dividend stock is just like a regular share with one notable exception: you are also entitled to a share of the profits from the company (or retained earnings as they’re more correctly called). Even if you buy that share of the company at $1 and sell at $1, you’ve still made money along the way with the dividends you’ve collected.
Why does a company have dividends
There may be several reasons why a company declares dividend including:
- They’re a large company that doesn’t expect much growth and therefore it makes sense to distribute profits rather than reinvest them.
- They’re a company that is seen as a risky investment and you want to attract speculators.
How are dividends paid?
Cash in your brokerage account
Dividends paid to you by company’s that you own stock in appear in your brokerage account as cash. You can then decide to withdraw that cash or buy new stocks (even the same company who paid you the dividend. See DRIPs later on in this post for a smart way to do it).
Most dividends are paid on a quarterly basis. This also makes them perfect as an income stream from your investment.
When do you need to buy a stock by to get the next dividend
The “ex-dividend” date is the date that you need to buy the stock so that you qualify to receive the next dividend. After all, it wouldn’t be fair if you could buy the stock the day before the dividend payout and still get the dividend. Dividends are meant to reward long-term holders of a stock.
Confusingly, the ex-dividend date is set by declaring something called a record date and then working backwards by a couple of days. But what you really need to know is that you need to have held the stock in your brokerage account for a little while before you can expect a dividend and that you should try and time it so you meet the criteria for getting that dividend as soon as possible after buying that stock.
What should you look for in a dividend stock?
What’s the yield?
The yield of a dividend is how much money you receive versus the price of the stock. It’s normally expressed as a percentage.
Beware of very high yields as they often indicate risk in the underlying company, and an attempt to lure investors.
Average inflation rate over the past 20-years in the U.S. has been something like 3.2%, so you want your yield to ideally outperform that.
How long has the stock paid that dividend
Past performance is a reasonable indicator of future performance. If a company has been reliably paying it’s dividend for 10-years, you have some assurance that’s likely to continue. Of course, it’s not a guarantee.
One of the best scenarios is when a stock pays a solid dividend and that dividend yield grows over time.
Growth of the underlying stock
Don’t forget that you also own the underlying shares that power the dividend. If those shares are going up an average of 5% every year and the dividend is 4%, you’re making a whopping 9% return on your investment. Don’t forget that the converse is also true: if there’s a correction in the stock market, you might still get your 4% dividend, but might also have lost 5% (or more) of the underlying stock value.
Buying a dividend stock that’s unlikely to be able to continue paying out its dividend in the future goes against the passive income requirement of a dividend stock. Do some research before buying: has the stock paid out historically? Is the company likely to have enough cash to pay a dividend in the near future? What happens if the company doesn’t make a profit for one quarter?
There’re also situations where, for example, a company might be restructuring, it’s stock has taken a beating, and they’re trying to attract new investors with a dividend. Be wary of this scenario unless you’re really, really sure of the underlying investment.
A drip is not just something you get in your bathroom. It’s a Dividend Re-Investment Program[me] or DRIP.
DRIPs are something I’m also very fond of because they’re a great way to grow your investment in a dividend stock. Simply put, when the company pays you your dividend cash it’s automatically reinvested in that company’s stock. You don’t have to do anything, extra units of stock magically appear in your account. And because you own more of the company’s stock, you get more dividends the next time they’re paid out.
To put it more plainly, imagine I own one share of Fujirama Heavy Industries (this is not a real company). Fujirama pays a healthy 6% dividend. When the dividend is paid, I get cash equivalent to 6% of one share. That cash automatically gets reinvested and I end up with the equivalent of 6% of one share in stock.
Now, you’re saying, how on earth can you get a fraction of a share?! In this scenario your brokerage holds a round number of shares in the company and then gives each customer their fraction of that whole number.
The great thing about DRIPs is they give you the power of compounding the number of shares you own. You lose out on getting the cash from the dividend while this is going on but a great strategy is to hold DRIPs in you’re your account while you’re saving for retirement, then switch off the DRIP feature to create a passive income stream when you retire.
One final advantage of DRIPs. You generally don’t pay “buy” commission on your DRIP stock; you’re just given the extra stock by the brokerage sans fees. Talk about another way to accelerate your rate of return!
All this dividend talk is too complicated, but I want in!
Ever heard of an ETF (Exchange Traded Fund)? Somebody else can buy and manage all the dividend stocks and you get to invest in that fund rather than each stock and then you get a cumulative return of the dividends (plus whatever they make buying and selling the underlying stocks, too). ETFs tend to have lower fees than mutual funds, so they’re great for the value investor.
There are a whole heap of them with yields in the sweet spot of 4-6% and several that return substantially higher than that (but may well be riskier). They’re as simple to buy as a stock and can be held in most brokerage accounts. Two of the bigger names are Vanguard and iShares if you’re looking for a place to start your research.
Let’s Paint a Picture
This is a purely hypothetical scenario and not based on any particular stock. What I’m trying to illustrate is the long-term benefits of dividends and in particular adding regular contributions and using DRIPs.
Let’s just say you were lucky enough to have saved $10,000 of your hard earned money and you wanted to invest it in dividend stocks. You found a stock that you really like because you believe the company is solid. The company pays a 5% dividend and has shown growth of 5% per year of that stock price. They’ve also historically grown their dividend rate by 5% per annum.
Because you’re a committed investor, you’re also going to contribute $100 (from your side gig) going forward and you ask your brokerage to set everything up as a DRIP.
You’re 20-years from retirement, like me, and therefore you decide to keep this arrangement until you retire.
That initial $10,000 plus those monthly contributions would be worth $129,085.07 over that 20-year period.
Imagine you started at 25 and also wanted to retire at 65. This is a bit of a stretch because we have to assume the company will be around for 40-years, paying the same dividend and achieve growth, but it’s an illustration after all. You’d have a whopping $900k at the end. If we were to increase that monthly contribution to $250, you’d be sitting on $1.6mm at the end of things.
So, as you can see, dividends and especially DRIPs can be a powerful investment instrument and probably something any balanced portfolio should at least have a bit of.
Are you investing or planning to invest in dividends? Let me know!