Every income investor’s portfolio has to include dividend equities, but don’t think of them as just for retirees. No matter what your age or financial capability, dividend stocks have a place in any investment portfolio. Reason: Compounding.

Investing in dividend-paying equities has a snowball effect on an investor’s wealth. Reinvesting your dividends allows you to amass a greater shareholding, and a larger shareholding increases your dividend yield in the long run. Santa Barbara Asset Management‘s study shows that dividend reinvestment accounts for more than 40% of the S&P 500’s average yearly total return since 1930.

Investing in dividend-paying companies is a smart strategy to create a steady income and wealth flow. Investors are taking on more risk, but the potential reward is larger as well. Making money with these assets doesn’t require a degree in math or physics, but it does necessitate familiarity with a few fundamental concepts.

In this article, we’ll be giving you the ultimate starter guide if you wish to start your dividend stocks journey.

To make it easier for you, we’ll be breaking down our discussion by answering the following questions:  

• What exactly is a dividend?

• What makes a preferred dividend different from a special dividend?

• Why do people buy stocks that pay dividends?

• What are the benefits and drawbacks of investing in dividend stocks?

• How much do you need to invest in dividend stocks?

• How can you pick the best stocks that pay dividends?

What Exactly Is A Dividend?

A dividend stock is a share of a public company that regularly gives dividends to its shareholders. Most of the time, these companies make money and promise to pay dividends for the foreseeable future. Dividends can make up a big part of an investor’s total return over time, even though they may not be as exciting as chasing after the latest stock market star.

Dividends are a way for shareholders to share in the growth of the business even if the price of their shares hasn’t gone up. This can happen through cash dividends or stock dividends.

Most dividends in the United States are cash dividends, which are cash payments made to investors based on how many shares they own. 

For example, if a company pays 20 cents per share dividend, an investor with 100 shares would get $20 in cash. When you get a stock dividend, the number of shares you own goes up by a certain percentage. If an investor has 100 shares and the company gives out a 10% stock dividend, the investor will now have 110 shares.

Preferred Dividend Versus Special Dividend

Even though no dividend is guaranteed, some are more important than others. People who own preferred dividends have a higher claim on a company’s assets than people who hold common stock but a lower claim than people who own bonds.

When a company has to cut its dividends, it starts at the bottom and works its way up. It will pay bondholders first, then preferred stockholders, and if there’s still money left, it will pay common stockholders.

When times are good, companies use the same hierarchy to decide how to spend their money. They usually pay preferred shareholders first and give them a bigger dividend than they give to common shareholders.

The special dividend is another kind of dividend. Special dividends are like bonuses that you get in addition to your regular dividends. They are one-time dividend payments that a company might give after a good quarter or if it wants to change the way its finances work. Most of the time, these extra dividends are paid in cash, and they are often bigger than regular dividends.

Why People Buy Dividend Stocks

Even though dividends aren’t a sure thing, many investors count on them as a way to make money. Because firms pay dividends at different times, retirees can set up a program to receive a dividend check every month of the year, according to Bill McMahon, Senior Vice President, and Chief Investment Officer of active equities strategies at Charles Schwab Investment Management in Boston.

Younger investors, who may not need the income right now, can put the dividends to work in their portfolios right away by reinvesting them. This is done automatically by dividend reinvestment plans, but even if you reinvest your dividends, you still have to pay taxes the year you get them. Like an individual retirement account, dividends in a tax-advantaged account grow tax-free until the money is taken out.

Benefits And Drawbacks Of Investing In Dividend Stocks

Before deciding whether to invest in dividend stocks or not, a rule of thumb is to weigh the PROs and CONs. As with any other type of investment, it’s not enough that you understand how it works. What matters more is that the advantages are more than the possible risks. 

In this section, we’ll be looking at the benefits AND the possible drawbacks of investing in Dividend Stocks.

Let’s start with the benefits. 

Not Affected By The Stock Market

One of the many benefits of dividend-based investing is that it protects you from the stock market. It’s not very easy to know what will happen in the stock market. Stocks go up and down based on what investors want and what huge hedge funds and other large companies do.

Warren Buffet, a well-known investor, thinks that no one can predict how these actions will go. He once said that no investor could use technical analysis to do better than the market over a ten-year period.

People try to guess which events will tip the stock market and make securities more profitable. This makes stocks go up and down.

The average investor doesn’t have the same technology or access to information as many institutional investors, so they are also at a disadvantage in these guessing games. Also, buying stocks is not as easy for them as it is for other people. Most brokerages make money every time you buy or sell a stock. When investors buy or sell, they may have to pay a small fee. This cuts into any profits they hope to make by buying low and selling high.

Volatility

Not all dividends change in the same way. Investing in dividends is based on a few assumptions that are baked in each quarter.

Several things can be used to determine what a company’s dividend will be. Companies that are young and growing expect that their rapidly rising stock price will attract investors and that they won’t need to do anything else to keep those investors. Because of this, those dividends will not be huge.

Also, smaller or bigger, weaker companies won’t be able to pay dividends because they won’t have the money to do so.

Instead, an investor can look at a company’s history of paying dividends and safe, reliable cash flows and assume that the company will continue to pay reliable dividends in the future.

Reliable Income Source

A dividend investor can use the reliability of dividends to grow their portfolio in a way that is different from how the stock market is usually done. The traditional way to make money on the stock market is through fluctuations that are hard to predict. Most of the time, gains will be followed by losses.

The magic of compounding is much more relevant when it comes to dividends. The way interest grows is called “compounding.” This is especially true when dividends are reinvested as part of a Dividend Reinvestment (DRIP) plan.

The rule of 72 is the best example of how compounding works. It is a concept used to estimate, in years, how long it will take an investment with a particular interest rate to double.

Investors who use a DRIP can figure out how long it will take for their money to double just from dividends, without growth, by multiplying dividend 72 by the current dividend yield.

For example, a stock with an 8% yield, like Dividend King Altria (MO), would double about every nine years just from the reinvested dividends.

During times of uncertainty and when savings accounts only earn a few tenths of one percent per year, a way to invest that can quickly double a person’s money will be a very profitable and attractive option.

Let’s talk about the possible disadvantages of investing in stock dividends. 

Companies With Little Growth

Most growing companies don’t pay dividends to their shareholders because they use their profits to grow their businesses. For example, they might open new plants, move into new cities, buy new equipment, buy small companies, etc.

On the other hand, big companies that have been around for a long time don’t have as many chances, so they make a lot of money for their shareholders. When people buy dividend stocks, they may be putting their money into low-growth companies that don’t always pay off well.

Risks Of High Dividend Payouts

When a company pays out a lot of dividends, it means that it gives most of its profits to its shareholders. If a company, for example, made a profit of Rs 100 crores in a financial year and gave out Rs 85 crores as dividends, this means that the dividend payout ratio is 85%.

At first, it might seem good for the shareholders. After all, they get most of the profit in the form of dividends. However, it might not be very suitable for some investors in the long run.

Look at it from a different point of view. When a company doesn’t keep enough of its own profits, it doesn’t have much money left over to put back into its growth. And if the company doesn’t reinvest enough, it might have trouble growing, competing with other businesses, or even keeping the same net profit in the years to come. 

Also, if the company doesn’t grow or make more money, it won’t be able to give its shareholders more value or raise dividends in the future.

Taxes On Dividends

Taxes did not have to be paid on dividends until March 31, 2020. (FY 2019-20). But the Finance Act of 2020 changed how dividends are taxed. Now, dividends are taxed when they are given to shareholders. (Companies and mutual funds no longer have to pay for DDT like they used to.)

The tax burden was put on the companies and Mutual Funds instead of the people who got the money. So, starting in FY 2020-21, dividends from domestic companies and mutual funds will be taxed at the rates that apply to the shareholders and unitholders.

How Much Would You Need

The specific portion of your portfolio to allocate to a dividend strategy will be determined by your risk tolerance, investment time frame, and income needs.

What you have to keep in mind is that dividend stocks are not bonds that guarantee the return of your principal. Dividend stocks, like any other stock, are subject to market and company-specific risks.

Furthermore, dividend stocks are subject to interest rate risk. When interest rates rise, investors may flee dividend stocks in favor of bonds’ guaranteed income, causing dividend stock prices to fall.

How To Pick The Best Dividend Stocks

The biggest question that you probably have now that you got up to this point – is how to pick the best dividend stocks to invest in. Here are some factors that you should look at before you decide: 

Strong Cash Position, Low Earnings Forecast

Long-term profitability is an essential factor to consider when evaluating dividend-paying companies. Although any company can have a profitable quarter on occasion, only those with consistent annual growth should be considered. Investors should look for companies with long-term earnings growth expectations ranging between 5% and 15%. However, companies with growth rates greater than 15% are more likely to experience earnings disappointments, resulting in a drop in stock price.

Following that, investors should look for companies with solid cash flow generation, which is required to pay dividends.

Finally, a minimum five-year track record of strong dividend payouts indicates that dividend growth will continue. Of course, investors must purchase their shares prior to the ex-dividend date.

Keep Debt To A Minimum

Dividend-paying companies with excessive debt should be avoided by investors. Simply put, companies with debt tend to direct their resources toward debt repayment rather than dividend payment programs. As a result, investors must scrutinize a company’s debt-to-equity ratio. If it is greater than 2.00, proceed.

Examine Industry Trends

While scrutinizing a company’s numbers is essential, it’s also important to look at the broader sector in order to develop a more holistic projection of future performance. For example, an oil company may be doing well, but a drop in oil prices will likely increase demand while decreasing supply. This could lead to a drop in stock prices and a reduction in dividend payments.

Another example is the aging baby boomer population, which will inevitably increase the demand for healthcare services over the next several decades. Although this does not necessarily guarantee the performance of any single healthcare provider, healthcare stocks are generally strong enough to withstand market downturns. This paves the way for future dividend gains to be consistent.

Keep in mind that the behavior of any sector can change over time. Investing in the soft drink industry, for example, has historically been a safe bet, but consumers are becoming more health-conscious. As a result, the majority of major beverage companies are shifting their focus to healthier/alternative drink options. This transition, however, will take time. Before investing in the names of beverage companies, investors should be aware of this.

Key Takeaway

When searching for businesses in which to invest in dividend stocks, you should seek those that have long-term projected earnings growth of between 5 and 15 percent, robust cash flows, low debt-to-equity ratios, and significant industrial strength.