Dividend Investing: A Beginner’s Guide to Picking Stocks for Income

Your investment strategy should be determined primarily by your financial goals. If earning a recurring, passive income from a portfolio that doesn’t require constant monitoring sounds good to you, you may want to look into dividend investing.

What is a dividend?

One way of thinking about dividends is as rewards for being a loyal shareholder. Companies offer cash payouts, and occasionally new shares, to those who own their stock as an incentive to buy and hold shares of the company instead of using them as a vehicle for speculation.

From another point of view, a dividend is simply the company giving back a percentage of its profit to its de facto owners. It is not obligatory to pay dividends, and many companies, especially when growing fast, choose not to pay one, instead reinvesting revenue tin future expansion. The board of directors of each enterprise decides on the amount of the dividend, after which it is approved by a shareholder vote.

Is dividend investing right for me?

The idea behind dividend investing is to earn a steady cash income from your stock ownership. Whether your holdings increase in value, while important, is a secondary consideration. The desired outcome is that dividends eventually make up a major source of your income, and may be your only source of income once retired. When dividend investing is done successfully, it can bring your retirement date forward or leave you more comfortably off once you do decide to retire.

Of course, investing for dividends does not necessarily mean waiting until you’re in your sixties. The dividends paid by any stock you own are always a welcome source of cash and can be spent as you wish. However, we will shortly explain the benefits of reinvesting these dividends.

A distinction is often drawn between dividend investing (or income investing) and growth investing. Investing for growth means buying the stock in the hopes of selling it later at a higher price. In this case, your profit amounts to the difference between the buy and sell prices. In reality, investing strategies are rarely that black and white; many of the most desirable stocks show steady growth as well as paying dividends.

How do dividends work?

Traditionally, dividends are paid in cash every three months, corresponding to the company’s financial quarters. But variations on this scheme do exist, such as shareholders being paid in additional shares or dividends being disbursed annually, monthly or on a special one-off basis. Your broker will typically offer you the option of having the cash deposited into your brokerage account or automatically reinvesting dividend payments back into the same stock.

A few different dates should be kept in mind when investing for income, as these all play a role in your dividend payout. The first is your trade date, i.e. when you bought your shares. The second is the settlement date because, although you may have placed the trade before the stock exchange closed, the trade might only have been settled on the next business day. In the meantime, you have effectively and legally taken ownership of the stock, even allowing you to even sell it…but settlement and trade dates are distinct for administrative purposes. These kinds of settlement dates are known as T+1. The settlement date is typically what determines whether you are eligible for the dividend.

The third date to consider is known as the declaration or record date, which is when a company’s board of directors choose to declare the dividend. The fourth date is the ex-dividend date; this is set by stock exchange rules and usually falls one or two days before the record date. You have to own the stock before the ex-div date to qualify for the dividend. Shareholders who bought the stock on or after it went ex-div are excluded from the upcoming dividend payment. Saving the best ‘til last, we also have the payment date, when the dividend is actually paid out.

Looking at historical data, you will notice how stock prices often rise when a dividend is declared, as this is a signal that the company is doing well. However, a share price typically drops on its ex-div date because market makers are adjusting the price of the stock that no longer includes the forthcoming dividend.

How will my dividends go up?

There are basically only two ways in which the amount of your dividend can go up:

The company raises the dividend
You own more stock

These points should inform any sensible dividend investing strategy. In other words, if you are investing in a company that has a good track record of steady or increasing dividends, and you increase your stock holdings on a regular basis, you’ll earn more money each quarter. Buying more of the stock can be done by investing a fixed proportion of every paycheck or reinvesting your dividend payments.

Reinvesting dividends

Without getting too poetic, this is how the magic happens with dividends. It amounts to the power of compound interest, the mathematical wizardry Einstein supposedly called the eighth wonder of the world.

The concept is simple: instead of dividend cash being paid into your bank or brokerage account, each payment is automatically reinvested into the same stock. This can be done through a DRIP (Dividend Reinvestment Program) through the company itself or via an agreement with your brokerage, which might involve a transaction fee.

But I want the money now! Of course, we’d all like to enjoy the passive income from our investments in the present, but there are some major advantages to reinvesting them instead. Over the long term, you increase your stake in the company, thereby augmenting the size of the dividend you are entitled to next time.

As they say, pictures don’t lie:

When a dividend investor looks at the price history of an investment, there are two versions for them to consider. The first is the “price change”, which is simply the change in the share price. Secondly, there is also the “total investment return”, which shows what someone would have gained by reinvesting the dividend.

The above chart assumes an average annual share price growth of 5%. An investment of $1,000 would double in 30 years, to $2,000, if dividends are taken as cash. However, that same $1,000 would return $4,000 if the dividends are reinvested! In the best-case scenario, that same investment would grow to $9,000 if the company raises the dividend by 4% each year.

How to pick good dividend stocks

There are a number of different ratios and quantitative and qualitative measures you will want to consider when deciding whether to invest in a dividend stock. However, none of these numbers should be taken in isolation but instead considered holistically. The best approach is to gain a complete picture in which a weight of evidence emerges as to whether the stock will make a good income investment. In essence, as many of the factors below ought to back each other up to help you form a decision. Unlike day trading, dividend investment is a long game, so there’s no reason not to take your time with research.

The most important factors to consider are:

Dividend yield

The dividend yield is defined as how much you are getting paid in dividends for every dollar invested in a stock.

For example:

You own 1 Apple share, worth $100. After a brief calculation, we determine that your total investment is therefore worth $100. Now, if Apple pays a dividend of $10 per share annually, you earn an annual dividend of $10 from owning the stock. Since you earned $10 from your $100 investment, your dividend yield is 10%.

So the highest dividend yield is best, right? Hold your horses: if Apple’s stock price rises to $200 next year, you will still earn $10 but from an investment worth $200, which translates to a dividend yield of 5%.

The dividend yield should, of course, justify making an investment, which could of course be placed in any number of securities. Secondly, it should be commensurate with that paid by competing companies, namely stocks with similar investment outlooks, as well as with benchmarks like the S&P 500. When reviewing historical data, interest rates set by central banks should also be taken into account. When these are low, dividend yields tend to follow suit.

On the other hand, a very high dividend yield can be a bad omen. You need to avoid what is called the “dividend trap”, when a company pays such unsustainably high dividends that its dividend yield will probably have to be reduced or cut altogether. As one example, let’s say XYZ Corporation’s stock price plummets after the company issues a profit warning. The dividend yield suddenly looks very attractive, not because the dividend amount has increased but because the stock is cheap. However, as soon as the company reports its earnings, investors see that the profits have dropped exactly has been warned about. The board of directors cuts the dividend because XYZ no longer has the profits to pay it.

Payout ratio

The payout ratio is a representation of how much of its earnings the company is paying out as dividends. It is calculated as follows:

Naturally, a company that pays out a smaller percentage of its earnings has greater scope for raising its dividend later. Since undistributed earnings are generally invested back into business operations, there’s also a chance that total revenue will be greater in the years to come.

A business that already pays out a large portion of its profit to shareholders has less room for growing its dividend and, indeed, a greater likelihood of cutting it. A payout ratio of 50% is generally considered the dividing point between high and low dividend payout ratios.

Coverage ratio

This number gives you a quick feeling about how capable a company is to pay its dividend. It basically shows how many times a company could pay its dividend using its net income over a year. The coverage ratio is therefore directly related to the payout ratio. In general, the higher the better, since the business’s profitability makes the dividend more sustainable.

Track record

It makes a lot of sense that a company with a track record of growing its dividend payouts will continue to do so. This is by no means a guarantee, but it at least shows past intent and ability to grow the dividend by the management and the board of the company. These often have an official dividend policy, which may be found in quarterly reports or on their investor relations web page. If you buy a stock whose dividend has been kept steady year after year, you limit your possible future returns.

One ratio to measure track record is the “dividend growth rate”, which is simply the annual growth rate of the dividend of a stock over a period of time, usually the past five years.

Steady earnings growth

It goes without saying that a company must first make a profit before it will be able to pay a dividend. For an income investment, steady earnings growth is usually better than fast earnings growth. A technology startup, for instance, may have had soaring profits in the past few years but cannot necessarily guarantee that this situation is sustainable.

To a dividend investor, consistent earnings are a sign that a company can reliable pay good dividends in the future. The variable most commonly watched by investors during earnings season is Earnings Per Share (EPS). EPS growth is simply a measure of the change in earnings from one year to the next.

For example, earnings will fluctuate according to changes in the business environment, like we can see in the Imperial Brands chart below. However, as long as profits remain high enough to maintain an acceptable coverage ratio, the dividend can still be reliably grown with minimal risk of being cut.

Valuation

As with any stock market investment, valuation matters. The primary reason to make an income stock investment is not capital appreciation (an increase in the stock price), but you still don’t want to see the company tank! If a stock is overvalued relative to its expected earnings, one of those two data points has to change until the share price reflects a sensible valuation.

When investing for income, you don’t want to risk all your dividend payouts being offset by a decrease in stock price. Just like in value investing, it’s advisable to restrict your investments to companies with a Price-Earnings (P/E) ratio in line with others in the same industry and/or a market benchmark like the S&P 500 (or some other appropriate index if outside the United States). There is no single rule of thumb to follow for P/E. In general, though, you could say that any figure over 20 is rather high.

Competitive advantage

Some factors influencing dividend investment decisions can’t be put into numbers; you may have to make a qualitative judgment about the company to decide whether it is a good bet. Very first things first – do you know what the company does? If not, follow Warren Buffett’s rule: step aside and let somebody who does understand the industry invest. You should only place your faith in companies whose link between product and profit is clear to you. If this is not the case, it will be difficult to say whether they will be successful in the long run.

It is a company’s competitive advantage that allows it to keep its market share over time because it satisfies some kind of customer need better than others can. This edge in the market could originate from a natural monopoly, brand recognition, patent ownership, or other strengths. The point to look out for is that the company delivers a product or service that others cannot easily replace.

Conclusion

Dividend investing is an attractive route to passive income. When you apply the power of dividend reinvestment and compound interest, it can make a huge difference to your financial position when you retire.

Though investing for income is, in some ways at least, less complicated than trading based on technical analysis, it’s by no means straightforward. If you’re a novice at investing, the fees charged by a financial advisor or a dividend ETF will probably be well worth the cost of mistakes avoided.