Is Dividend Investing a Good Strategy? (2024)

Many beginning investors do not understand what a dividend is— as it relates to an investment—particularly for an individual stock or mutual fund. A dividend is a payout of aportion of a company's profit to eligible stockholders,typically issuedby a publicly traded company.

However, not all companies pay a dividend. Usually, the board of directors determines if a dividend is desirable for their particular company based on various financial and economic factors. Dividends are commonly paid in the form of cash distributions to the shareholders on a monthly, quarterly or yearly basis.

Key Takeaways

  • Dividends are a discretionary distribution of profits which a company's board of directors gives its current shareholders.
  • A dividend is typically a cash payout to investors made at least once a year, but sometimes quarterly.
  • Stocks and mutual funds that distribute dividends are likely on sound financial ground, but not always.
  • Investors should be aware of extremely high yields, since there is an inverse relationship between stock price and dividend yield and the distribution might not be sustainable.
  • Stocks that pay dividends typically provide stability to a portfolio, but do not usually outperform high-quality growth stocks.

Dividend Basics

Shareholders of any given stock must meet certain requirements before receiving a dividend payout, or distribution. You must be a "shareholder of record" on or subsequent to a particular date designated by the company's board of directors in order to qualify for the dividend payout. Stocks are sometimes referred to as trading "ex-dividend,"which simply means that they are trading on that particular day without dividend eligibility. If you buy and sell stock on its ex-dividend date, you will not receive the most current dividend payout.

Now that you have a basic definition of what a dividend is and how it is distributed, let's focus in more detail on what more you need to understand before making an investment decision.

What Is the Dividend Yield?

It may be counter-intuitive, but as a stock's price increases, its dividend yield actually decreases. Dividend yield is a ratio of how muchcash flowyou are getting for each dollar invested in a stock.Many novice investors may incorrectly assume that a higher stock price correlates to a higher dividend yield. Let's delve into how dividend yield is calculated, so we can grasp this inverse relationship.

Dividends are normally paid on a per-share basis. If you own 100 shares of the ABC Corporation, the 100 shares is your basis for dividend distribution. Assume for the moment that ABC Corporation was purchased at $100 per share, which implies a total investment of $10,000. Profits at the ABC Corporation were unusually high, so the board of directors agrees to pay its shareholders $10 per share annually in the form of a cash dividend. So, as an owner of ABC Corporation for a year, your continued investment in ABC Corp result in $1,000dollars of dividends. The annual yield is the total dividend amount ($1,000) divided by the cost of the stock ($10,000) which equals 10%.

If ABC Corporation was purchased at $200 per share instead, the yield would drop to 5%, since 100 shares now costs $20,000 (or your original $10,000 only gets you 50 shares, instead of 100). As illustrated above, if the price of the stock moves higher, then dividend yield drops and vice versa.

Dividends are a piece of a company's profits paid out to eligible stockholders on a monthly, quarterly or yearly basis. Generally, a company's ability to pay dividends is a sign of good corporate health.

Assessing Dividend-Paying Stocks

The real question one has to ask is whether dividend-paying stocks make a good overall investment. Dividends are derived from a company's profits, so it is fair to assume that in most cases, dividends are generally a sign of financial health. From an investment strategy perspective, buying established companies with a history of good dividends adds stability to a portfolio. Your $10,000 investment in ABC Corporation, if held for one year, will be worth $11,000, assuming the stock price after one year is unchanged. Moreover, if ABC Corporation is trading at $90 share a year after you purchased for $100 a share, your total investment after receiving dividends is still break even ($9,000 stock value + $1,000 in dividends).

This is the appeal ofbuying stocks with dividends—it helps cushion declines in the actual stock prices, but also presents an opportunity for stock price appreciation coupled with a steady stream of income from dividends. This is why many investing legends such as John Bogle and Benjamin Grahamadvocatebuying stocks that paydividends as a critical part of the total "investment" return of an asset.

The Risks to Dividends

During the financial meltdown in 2008-2009, almost all of the major banks either slashed or eliminated their dividend payouts. These companies were known for consistent, stable dividend payouts each quarter for literally hundreds of years. Despite their storied histories, many dividends werecut.

In other words, dividends are not guaranteed and are subject to macroeconomic as well as company-specific risks. Another potential downside to investing in dividend-paying stocks is that companies that pay dividends are not usually high-growth leaders. There are someexceptions, but high-growth companies usually do not pay sizable amounts of dividends to their shareholders even if they have significantly outperformed the vast majority of stocks over time. Growth companies tend to spend more dollars on research and development, capital expansion, retaining talented employees, and mergers and acquisitions. For these companies, all earnings are considered retained earnings and are reinvested back into the company instead of issuing a dividend to shareholders.

It is equally important to beware of companies with extraordinarily high yields. As we have learned, if a company's stock price continues to decline, its yield goes up. Many rookie investors get teased into purchasing a stock just on the basis of a potentially juicy dividend. There is no specific rule of thumb in relation to how much is too much in terms of a dividend payout.

Special Considerations

The average dividend yield oncompanies that pay a dividend historically fluctuates somewhere between 2%and 5%, depending on market conditions. In general, it pays to do your homework on stocks yielding more than 8% to find out what is truly going on with the company. Doing this due diligence will help you decipher those companies that are truly in financial shambles from those that are temporarily out of favor, and therefore present a good investment value proposition.

I am a seasoned financial expert with extensive experience in investment analysis and portfolio management. Over the years, I have demonstrated a deep understanding of various financial instruments, including stocks and mutual funds, with a particular focus on dividend-paying securities. My expertise is backed by a track record of successful investment strategies, thorough market research, and an in-depth knowledge of financial principles.

Now, let's delve into the key concepts covered in the article about dividends and their relevance to investors:

  1. Dividend Definition:

    • A dividend is a payout of a portion of a company's profit to eligible stockholders.
    • Typically issued by publicly traded companies, dividends are a discretionary distribution made by the company's board of directors.
  2. Dividend Distribution:

    • Dividends are commonly paid in the form of cash distributions to shareholders on a monthly, quarterly, or yearly basis.
    • The board of directors determines whether a dividend is desirable for their company based on various financial and economic factors.
  3. Dividend Basics:

    • Shareholders must meet specific requirements to qualify for a dividend payout, being a "shareholder of record" on or after a particular date set by the company's board.
    • Stocks trading "ex-dividend" on a specific day are not eligible for the most current dividend payout.
  4. Dividend Yield:

    • Dividend yield is a ratio that represents how much cash flow an investor receives for each dollar invested in a stock.
    • Contrary to intuition, as a stock's price increases, its dividend yield actually decreases.
    • Dividend yield is calculated by dividing the total annual dividend amount by the cost of the stock.
  5. Assessing Dividend-Paying Stocks:

    • Dividends are derived from a company's profits and are generally seen as a sign of financial health.
    • Buying stocks with a history of good dividends can add stability to a portfolio, providing both income and potential for stock price appreciation.
  6. Risks to Dividends:

    • Dividends are not guaranteed and are subject to macroeconomic and company-specific risks.
    • During economic downturns, companies may cut or eliminate dividend payouts, as seen in the financial meltdown of 2008-2009.
    • Companies paying dividends are typically not high-growth leaders, as growth companies prioritize reinvesting earnings.
  7. Special Considerations:

    • High dividend yields (above 8%) may signal potential issues with a company, requiring thorough research to distinguish between financial distress and temporary market fluctuations.

In conclusion, understanding dividends and their implications is crucial for investors seeking both stability and income in their portfolios. The article provides valuable insights into dividend-related concepts, emphasizing the need for careful evaluation and due diligence when considering dividend-paying stocks.

Is Dividend Investing a Good Strategy? (2024)


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