Want to see a return on your investment in the near future? Buy dividend stocks for your portfolio, and you’ll soon start receiving cash or additional shares for the stocks you own!
But before picking which stocks to buy and receive dividends from, it is important to know and understand how they work.
Just the Nuggets
- Dividends are paid to stockholders from the company’s profit, but each company decides for itself whether it will pay a dividend.
- There are two kinds of dividends: regular and special.
- To become entitled to a dividend, you need to own the stock before the ex-dividend date.
- Companies with a long history of dividend payments and stable profits are more likely to pay future dividends.
What is a Dividend?
The ultimate goal of any business is to turn a profit. A portion of that profit you’re entitled to as a stockholder is called a dividend.
Dividends are direct returns on investment in the form of cash, shares, or property, and this makes them one of the most logical reasons to build a stock portfolio.
How a Dividend is Determined
A company needs cash to run its existing operations and to finance new ones. So a company cannot pay out all its profits to investors in a single burst.
Before making a big decision, the management team needs to plan. They need to consider:
- how much money they need to finance the operations and expansions
- how much they need to put in reserves for years to come
- if it is possible to distribute dividends to stockholders and how much
Larger and established companies, who need less money for expansion, usually pay out larger dividends. Smaller and newer companies, who need more cash for projects, usually pay out smaller dividends and often none at all.
Companies with a long dividend-paying history are the best to buy dividend stocks from. More than 25 years of paying dividends is a strong track record. For example, the Dividend Aristocrats—companies listed on the NYSE with strong histories of paying dividends. They form the official S&P 500 Dividend Aristocrats index.
Kinds of Dividends
A company which intends to pay dividends can do so in two ways.
1. Regular dividends
These are paid on a periodic basis (yearly, quarterly, or even monthly). Companies with a long history of regularly paying dividends are likely to continue doing so.
2. Special dividends
These are paid after the company has had an extraordinarily successful period, or when simply it has accumulated more cash than it can put to use. In such cases, the company announces the dividend and highlights that it is special. This is to signal that the dividend is not a recurring event.
Important Dates to Remember
Dividends are paid on a per-stock basis—meaning, stockholders get a certain amount of money for each stock they own. To get in on the action, you must be able to know the significance of the dates relevant to a dividend payment. To better understand this concept—take this real-life situation for example, where Microsoft announced its quarterly dividend with the following dates:
1. Declaration Date
This is the day on which the company announces when and how much it will pay out dividends, as well as other important dates.
Dividends are announced on the stock exchange as a legal requirement. In the example, Microsoft declared on September 15, 2020.
2. Record Date
This is the trading day when the stockholders are identified and recorded.
Many stock exchanges have a rule about how many days before the record date the stockholders must hold the stock. Check with your broker for these record dates if you wish to become eligible for a dividend on a stock. In the example, shareholders of Microsoft are recorded on November 19, 2020.
3. Ex-Dividend Date
This is the trading day before the record date.
This date is set by the stock exchange. Stockholders who buy the stock on or after this day have no right to the declared dividend. Instead, the dividend will be paid to the seller. In the example, Microsoft’s ex-dividend date is November 18, 2020.
4. Payment Date
This is the day when dividend payments are sent to the recorded stockholders.
In the example, Microsoft will pay on December 10, 2020.
How to Receive the Dividend
On the payment date, the company will distribute by:
- sending the money to the stockholders’ brokerage accounts
- mailing a check to stockholders
- sending the money to the stockholders’ bank accounts
The method varies from country to country. You should check with your broker for the specific rules if you are expecting a dividend payment.
The Dividend Effect
On the ex-dividend date, the stock price will drop by roughly the amount paid out as a dividend. This happens because the market price is adjusting to account for whatever is paid for dividends. Stockholders who will receive the dividends are not affected by this effect.
In this example, Microsoft’s stock price dropped on the ex-dividend date. On August 18 (the day before the ex-dividend date), the stock price was $211.49. On August 19 (the ex-dividend date), the stock price was $209.70—$0.56 of that $1.79 total drop in stock price was caused by Microsoft paying a dividend.
Analyzing Stocks for Dividends
Analyzing for dividends should be a part of your entire analysis process. After looking at the company’s financial statements, you can then begin looking at the dividend track record.
1. Dividends Per Share (DPS)
Historical dividends paid per share by the company.
2. Earnings Per Share (EPS)
How much net profit per share they made.
3. Dividend Payout Ratio (DPR)
How much of the company’s net profits were given to investors.
4. Dividend Yield Ratio
How much you would get as a return on investment in percentages.
Note that Trailing Dividend Yield means the last paid dividend, and Forward Dividend Yield means the next announced dividend.
When buying dividend stocks, look for companies with a proven track record of paying dividends. They also need to have good performance and available cash. Once you have a shortlist of potential targets, pick a stock with a good dividend yield ratio at the moment.
How to Buy Dividend Stocks
Preparation and timing is the key to buying dividend stocks, and you should always follow these core steps.
1. Find a list
Search a list of dividend stocks on the stock exchange you’re trading. All stock exchanges publish lists of their stocks with key indicators, and you can use one as a base list.
2. Look at the indicators
Look at the earnings per share and dividend per share. These are the two most important indicators in the published stock lists.
3. Calculate formulas
Determine the dividend payout ratio and dividend yield ratio. If they are not available in the published list, you can easily calculate them using the formulas provided above.
4. Make a shortlist
From this point on, you’ll only be interested in stocks with the highest dividend yields and payout ratios. Sort your list from highest to lowest dividend yield, and then sort the highest yielding stocks from highest to lowest payout ratios.
5. Check the record dates
Remove stocks with record dates that are passed from your shortlist. The stocks on this list are the final candidates.
6. Buy the stocks on your final list
This will depend on which stocks will be available and at what price. For example, if the asking price is high and it doesn’t provide the expected dividend yield, don’t buy it.
7. Hold the stocks during record dates
This is for you to be recorded as a stockholder entitled to receive the dividend. You will receive the dividend on the payment date.
Do not confuse buying stocks for dividend yields and day-trading the dividend effect. Day trading is done with derivative rights over the stock, and attempting to do this with stocks will leave you only breaking even in the best case.
How Long Should You Hold a Dividend Stock?
Since the ex-dividend date is one business day before the record date, technically, you can own and hold your dividend stocks for two business days—which counts from the day before the ex-dividend date up to the record date.
You can hold your stocks for longer, but there should be a good reason to do so.
Unless the company is underperforming, or the dividend stock makes too much of your portfolio, or it is causing you a tax burden—a solid performing stock with regular dividends should not be sold from your portfolio.
Are Dividends Taxable?
Indeed, they are. Most countries in the world treat dividends received as income, while a few treat them as capital gains. In some countries, companies deduct shareholders’ taxes from the dividends they received and pay the taxes on behalf of them. While in others, companies just leave that as shareholders’ responsibility.
So keep in mind: Will the dividend income cause you to reach some progressive tax threshold? Will you need to pay the tax yourself?
The following are risks in buying dividend stocks you need to be careful of:
- If the company experiences a bad business cycle, it may stop paying out dividends.
- Using the wrong trading strategy, like trying to capture the dividend effect, can be a waste of time and money.
- Not estimating the tax effect of your dividend income may increase your tax burden.
These risks are relatively easy to mitigate, as explained in this article. But if these risks seem like too much work—you can always opt for an investment fund that focuses on dividend stocks. That will come at a fee of course.
Buying stocks to receive dividends is one of the most important steps in an intelligent investor’s portfolio building. If you have a portfolio but haven’t bought any dividend stocks, you need to do so. If you are just starting to build your portfolio, buying these stocks is a great first step.
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