All investors aim to grow their wealth and to achieve this, they follow different investment strategies. Purchasing the stocks of companies that pay steady dividends is a great way to invest. Since you invest for regular payments in solid companies, many investors might call it a boring investment strategy. However, a steady income is never dull.
Whenever you invest in the stocks of a company, you own a part of the company. If the company generates profits, it can use the cash to distribute it amongst the shareholders through dividend payments. Hence, dividend income is like earning interest from the bank for holding the money in a bank account. The annual dividend yield is the rate at which the company will pay dividends each year. This rate can vary and is based on the profits generated by the company.
For investors saving for retirement, regular dividend income is a safe way to grow their wealth. When an investor chooses to invest in companies that pay regular dividends, it becomes a source of cash flow and turns the investment into a retirement paycheck. Previous generations preferred dividend investment, and they certainly enjoyed higher yields than the one available today. But there is a lot of upside to a dividend growth strategy.
The Dividend Growth Investing strategy is one of the favorite strategies of investors who are saving for retirement and investing for the long term.
What is Dividend Growth Investing?
Dividend growth investing is simple. It is an active investment strategy that allows the buying and holding of several shares. You can build an investment portfolio by choosing companies with a strong track record of paying growing and reliable dividends year after year. As a dividend investor, you do not spend days looking for good buys through the financial pages. You pick stocks based on their dividend payout and history. The theory is that companies that meet these conditions should be picked.
- More likely to raise the dividend each year
- Have mature businesses
- Less likely to cut the dividend in the future.
Such companies are attractive to investors. With Dividend Growth Investing, you generate passive income and enjoy capital gains from the rise in share price. Investors build their portfolios like an income-generating machine, and they measure success by the value of the dividend the portfolio earns each year.
Dividend yield vs. Dividend growth
There is a difference in the company's dividend yield and dividend growth, and investors should be aware of the same.
You can calculate the dividend yield by dividing the annualized dividend payout of the stock with the current share price. If the company pays an annualized dividend of $3 per share and has a share price of $60, the dividend yield will be 5%. When the price of the share rises, the dividend yield will drop. Keep in mind that the payout will not change, but the rise in stock price will reduce the dividend yield.
This annualized dividend payout is the latest quarterly payout times four. Hence, the dividend yield will continue to change as the stock price changes. If you notice a high dividend yield, it results from a higher payout or a decline in the stock price. Always look beyond the dividend yield to ensure that you choose the right stocks with a sustainable dividend payout.
Dividend growth is the increase in dividend payout per share annually. The companies that show a high dividend growth are financially stable. It is a sign that the company is growing and is generating high cash flows. Take a look at the dividend increases of the company when choosing stocks for dividend investing.
Dividend Growth Investing for Long term Portfolios
Investors who already own stocks are involved in a certain degree of dividend investing. More than 75% of S&P 500 stocks pay a dividend. The dividend yield may not seem like much, but it is still higher than the interest rates paid on your savings account. In the past, the annual dividend yield was as high as 5%, but recently companies have been cautious with the cash payouts and have cut the dividends.
Low savings account rates, as well as bond yields, give little competition to dividend stocks. Companies have less incentive to raise dividends. Many companies also prefer investing in new products and more research for growth instead of distributing the cash amongst shareholders.
You can easily find Dividend Aristocrat stocks to invest in. These are stocks that are a part of the S&P 500 index and the ones that have increased the dividend payout at least once annually in the last 25 consecutive years. Several companies are known as Dividend Aristocrats, including Chevron, AT&T, Emerson Electric, Procter & Gamble, Johnson & Johnson
, Target, and more. Investing in these companies' stock might be expensive, but the dividend income will be consistent and increasing each year.
How to choose dividend stocks
An important tool for evaluating the best dividend-paying stocks is the dividend yield. But simply going by the highest yielding dividend stocks could be a little deceiving. Let us take an example here. You recently invested in a stock that paid a $5 annual dividend and was valued at $100 for a share. However, the company’s business was under pressure, and the value of the share fell to $50, but it is paying $5 in dividends. The dividend yield will not increase from $5 to $10, and in this case, there is a clear sign of stress and not a sign of a healthy company. When you see the company has a declining share price, it means it might be facing problems, and you need to reconsider your investment choices.
Whenever you choose an investment company, ask yourself if it is stable enough to pay dividends and increase them over time regularly. There are dividend aristocrats that have consistently increased dividends over the years. Another way to measure a good company is to look at the dividend payout ratio. It will compare the earnings of the company to the dividend payment per share. When a company earns $3 per share in a quarter and pays a dividend of $1.5 per share, the payout ratio will be 50%.
A low payout ratio shows sustainable dividends but could also mean that the company should increase the dividend. If the payout ratio is 100% or more than 100%, the company is giving back more than it is earning, lowering the dividend. Always look for a steady payout ratio as it indicates that the company is mature and generates reliable returns in the industry.
You can pick the top stocks by ensuring a minimum dividend yield of 3%. It will ensure that your investment can return a sensible amount in the form of dividends. You must also ensure that there is a minimum dividend cover. Check the buffer in the company's financials and ensure that it has enough earnings to pay dividends. Nothing beats an unbroken track record of increasing dividends over the decade.
Ways to Invest in dividend stocks
There are different options you can consider for dividend growth investing. These options are not mutually exclusive, and you can mix and match them to meet your investment goals.
The easiest way is to pick individual dividend-paying stocks. The success or failure of this strategy will be based on your investment strategy and situation. It helps to build a diversified portfolio of individual stocks. However, you must keep in mind that all stocks, including dividend-paying stocks, are susceptible to market volatility. They might be less volatile than the market as a whole. You can open an account with an online brokerage and build a dividend-paying stock position.
ETFs and Mutual Funds
Some several mutual funds and ETFs focus on dividend-paying stocks from the dividend growth perspective. You can choose one, keeping the yield of the fund in mind. The funds invest in companies that have increased their dividend annually for the past ten years. These funds remain focused on dividend growth and will be less risky than investing in individual stocks.
How to use dividend growth investing to boost the returns
Irrespective of the yields, dividends remain a crucial element that can boost the overall investing returns. Investors who reinvest the dividend payment to purchase more shares of the stock can help the portfolio benefit from the compounding effects. Simply put, every dividend you reinvest will entitle you to more dividends in the future, and this will only strengthen your portfolio and returns. Simply reinvesting the dividends will double your gains.
Look for a high dividend yield
A classic strategy for dividend investing is looking for companies with adequate cash flow and paying quality dividends. Such investments will help generate income right away.
Look for high dividend growth
When investing for the long term, focus on growing companies even if they pay lower than the average dividend. You will notice that the yield is not very high, but as the company grows and generates a strong cash flow, the dividend growth will be significant. When you get the shares early, you have a chance of enjoying higher dividends in the long run.
Follow dividend capture
A more hands-on approach to generating dividend income, dividend capture does not require you to hold the company's shares for the long term or the entire quarter. But you only swoop in and get your hands on the shares right before the dividend is paid out. After you get the dividend, you can sell them and buy other stocks. However, this strategy is not as easy as it sounds. You will need to own the stock at least a few weeks before the dividend is due, and it could get risky and complicated. The stock price may fall after the dividend is paid, and you could lose more money than you earned from the dividend.
Tax benefits of dividend investing
You can enjoy tax advantages with dividend investing. All dividends are not treated in the same manner by the Internal Revenue Service. Instead, the dividends are divided into qualified and unqualified.
The Qualified dividends are taxed at a lower rate, and the ordinary or unqualified dividends are taxed as regular income. The majority of the U.S. corporations pay qualified dividends, which means if you own the stock for 60 days, the dividend income will be taxed at the long-term capital gains rate. Other dividends you earn from Master Limited Partnerships or Real Estate Investment Trusted will be classified as ordinary dividends and will be taxed as regular income. Lastly, the dividend received from Individual Retirement Accounts or tax-advantaged retirement accounts is not subject to tax until withdrawn.
Risks of dividend growth investing
Investment in the stock market involves risk, and dividend growth investing is not an exception. You must remember that dividends are not guaranteed, and they could raise or reduce at any point in time. Some of the major companies have reduced their dividends post the pandemic. But it is a slight risk.
Remember to diversify the portfolio and when choosing dividend growth stocks for investing, look for companies across different sectors and industries. Young companies will not pay cash dividends too soon. The trick is to choose the right companies and remain invested in them.
The bottom line
Dividends remain an integral component of return for stocks, and the companies that pay high dividends regularly are known as excellent investments. If they increase their payout levels consistently, they attract higher investment. Investors need to remember that diversification is the key. If you are looking for dividend investing and want to generate an income stream, you must understand the company's financials you are interested in.
Go through the company's balance sheet and try to understand its revenue, profit, and cash position. Ensure that the dividend is sustainable. However, remember that all investments in the stock market are subject to market volatility. Even the top dividend-paying stock will get a hit if the market falls. If you want to reduce the risk, consider mutual funds and ETFs that focus on dividend reinvestment. Make sure that your investment decisions are consistent with your investing goals.