A dividend stock is a type of stock that pays out dividends. Dividends are usually paid in the form of cash on a per-share basis to shareholders.
In order to receive dividends, you must invest in a company by a certain date (the ex-dividend date) in order to receive the dividend. You can think of it as a cutoff date for owning the stock.
In this piece, we'll walk through the definition of dividend stocks (answering the question, "What's a dividend stock, exactly?"), how dividend stocks work, how often dividends are paid out, why you may want to consider buying dividend stocks and the steps involved in buying dividend stocks.
What is a Dividend Stock?
A dividend stock is a type of stock in which the company pays out a portion of its earnings in the form of dividends.
Here's an example: Let's say you own 100 shares of a particular company's stock and the company pays out 50 cents in dividends. You'd receive $50 in dividend payments annually from that particular company.
Why do companies pay dividends?
You can think of dividends as a bonus for investors. Companies use dividends as a way to entice investors to stick around and keep investing in the company. As an investor, you may want to invest in several companies that offer dividend payments at the same time or during different times of the year. That way, you maximize the dividend potential of several types of companies all at once, possibly staggering them to receive dividends at certain times of the year.
It's a good idea to look for companies with a well-established track record that pay out regular dividends. In fact, larger, slower-growing companies may be more likely to pay dividends to their investors compared to smaller startups focused on growth. Larger companies are more likely to be profitable, while smaller companies typically try to reinvest their available cash back into the company in order to invest in the growth of the business.
We'll go over more information about how to choose dividend stocks later on in the article.
How Do Dividend Stocks Work?
Earning dividends is relatively simple! All you have to do is own stocks using a brokerage account or retirement plan like an IRA. When the time comes to receive dividends, the cash automatically gets put into your account or gets paid directly to you.
As you might imagine, the more complicated piece of the puzzle is actually deciding on the right kind of dividend stocks to own. You'll need to consider a wide range of factors, including the company's long-term expected earnings growth, strong cash flow, low debt and strength in its current sector.
The timing of your investment really matters. A company's board of directors must first approve a dividend and announce plans to investors. You'll also have to pay attention to a few key dates: the announcement date, the record date, the ex-dividend date, and the payment date. Let's take a quick look at the definitions of each:
- Announcement date: The announcement date is the date in which the company announces its plans to release a dividend payment.
- Record date: Shareholders as of the record date will receive the dividend payment.
- Ex-dividend date: The ex-dividend date, which is usually one business day before the record date, you will not receive the next dividend payment. The seller gets the dividend instead. Purchasing before the ex-dividend date allows you to get the dividend.
- Payment date: The payment date is the official day that you, as an investor, will receive a dividend payment.
You can usually choose how you want your dividends deposited. If you receive a cash dividend, you can have the money paid directly to you via check, have it directly deposited into your bank account or have the money stay in a cash account with your brokerage. You can also purchase more shares of the company stock instead of receiving the money in cash. It's important to note that some companies pay out dividends in the form of company stock or a combination of both cash or shares of stock.
How Often Are Dividends Paid?
Dividends are usually paid out quarterly. However, you may receive dividends monthly, biannually, annually or even in the form of special dividends. (Special dividends are one-time dividend releases that you can't count on to receive regularly. They are just what they sound like — one-time special dividends.)
For example, the Coca-Cola Company normally pays dividends four times a year, usually April 1, July 1, October 1, and December 15. The company's website indicates that shareowners of record can elect to receive their dividend payments electronically or by check in the currency of their choice.
When you do your research, companies' websites can give you a clear indication of how often the company pays out dividends.
Why Buy Dividend Stocks?
There are a number of reasons why you might want to invest in dividend-paying companies. Let's take a quick look at the reasons why you may want to invest in dividend payers. They can:
- Help you conquer rocky periods: If the stock market isn't doing well and you will not be able to profit on a sale of stock, dividends offer a way to still get paid even though a stock isn't increasing in value.
- Offer a hedge against inflation: Dividend stocks can offer a hedge against inflation, which means it can offset the decrease in your ability to purchase more items in an economy.
- Give you reliable returns: If you're looking for reliable, ongoing payments, you may want to consider purchasing shares of well-established companies to benefit over time.
- Offer access to a passive income stream: Dividend income is one of the best methods of earning money in your sleep. It's a way to access extra dollars without having to work for it, unlike in a job, where you trade your time for money.
- Offer preferential tax treatment: You may access a better tax rate, depending on the type of dividends you have. The tax rate on qualified dividends is 0%, 15% or 20%, depending on your taxable income and filing status. On the other hand, nonqualified dividends require you to pay the same tax amount as your regular income tax bracket. Achieving taxes on qualified dividends will offer the best bang for your tax buck, but note that if you're in the highest tax brackets, you'll pay more.
Steps to Buying Dividend Stocks
Now that you know the basics of dividend stocks, how do you actually invest in dividend stocks? Let's take a quick look at the steps you can take to make it happen.
Step 1: Consider your goals.
What are your goals? Do you want to invest for retirement income? Do you plan to live off of your dividend income and rake in dividends on a monthly or biannual basis? Depending on your future goals, these can help guide how you want to invest your money for dividends. If you need help determining the route you'd like to take with your investments, you may want to get a fiduciary financial advisor on your side to help you outline your approach.
Step 2: Evaluate potential dividend stocks.
It's a good idea to start out with some research before you choose dividend stocks to purchase. Check the dividend yield, which shows how much a company pays out in dividends relative to its stock price. If a company pays out a much higher dividend compared to other companies, it could be a red flag. For example, if every other company pays out 4% but one company stands out as paying 15%, be wary. The dividend yield formula is:
Dividend Yield = Cash Dividend per Share / Market Price per Share x 100
Look for a dividend yield between 2% and 6%.
You can also evaluate the dividend payout growth, which is the average percentage rate of growth of a stock over a specific period. You can calculate it using the following formula:
Dividend Payout Growth = Current Annual Dividend per Share/Previous Year Dividend per Share - 1 x 100
Look for a rate of 5% to 9% — anything over 10% is excellent.
Among certain other metrics, you can also take a look at the dividend payout ratio. The dividend payout ratio will tell you how much income the company puts toward company dividends. The dividend payout ratio formula looks like this:
Dividend Payout Ratio = Dividend per Share/Earnings per Share x 100
A dividend payout ratio around 80% means that a company could be putting too much of its income into paying dividends.
Step 3: Decide how many shares you want.
How much do you want to invest? Decide the number of shares you'd like to purchase based on the amount of money you'd like to invest. Also consider the amount of diversification you want in your investments. Investing in a single company's stock means that you aren't well diversified. Investing in a wide selection of companies may offer more diversification (and therefore, safety) because you spread your money out into a wide variety of investments. Investing in an exchange-traded fund (ETF) is a great option because they are a basket of securities that track an underlying index. If some stocks in this "basket" decline, others may go up, which means you can more easily balance losses.
Interested in investing in ETFs for dividend returns? Check out 8 Best Dividend Stock ETFs and How to Invest in Them.
Step 4: Invest.
Once you've considered your goals, stock options and have decided on the number of shares that you want, you're ready to buy!. You will usually choose between a market order (buying or selling a stock at the best available market price) and a limit order (where you indicate the price at which you want to execute your trade). A market order is usually best for buy-and-hold investors, but if you want to hone in on a specific price for a stock, a limit order may appeal to you.
Do Dividend Stocks Help You Meet Your Goals?
Dividend stocks may be a great way to successfully add to your portfolio. Ultimately, it's a good idea to understand whether dividend stocks make the most sense for your portfolio because they aren't right for everyone.
Learning about dividends can help you decide whether you want to use this passive investment strategy to boost your portfolio. Do your research, decide how many shares you want and then invest in the right dividend-paying stocks for your needs.
Learn more: How Many Dividend Stocks Should I Own?
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