Using a portion of your business's profits for dividend investing is a great opportunity for small business owners to generate an additional income stream, which is key to building wealth. Dividend investing generally provides two sources of possible profit: income from regular dividend payments and capital appreciation over an extended period of time.
Dividend investing can be an assured way for investors to make money, but it can be risky if certain pitfalls aren't avoided. Read on to learn what dividend investing is, why you should consider it and what to look out for when investing.
What is dividend investing?
To properly understand dividend investing, it's important first to understand what a dividend is. A dividend is a payout of a portion of a company's earnings to eligible shareholders. Dividends are typically issued by publicly traded companies – generally, a company's board of directors will meet to review the financials and determine if a dividend is warranted. If they determine it is, they will approve it, and declare the dividend, the size of the dividend, the record day and payment date. Dividends can be paid as cash distributions to shareholders on a monthly, quarterly or yearly basis.
There are two main types of dividends: regular, which are paid to shareholders consistently over time, and special, which are "one-off" payments that are paid after particularly profitable quarters or the sale of an expensive asset.
Dividend investing is investing in stocks that pay a dividend. The total amount of dividends paid out to shareholders relative to the net income of the company is referred to as the payout ratio, which provides a sense of how much money a company is returning to shareholders versus how much it is retaining.
Why invest in dividends?
Dividend investing is generally a safe and reliable way to gain income from stocks. Dividend investing has a two-pronged approach to rewarding investors: recurring dividend payments and capital appreciation.
With recurring dividend payments, when you invest in dividends, you receive payments for as long as the company can support them, regardless of whether the company's stock price is up or down.
Capital appreciation, which is the increase in price or value of a company's assets, can also provide a stable flow of income.
What to look for when investing in dividends
Dividend safety: When looking at where to invest or buy a share, one of the most important things you can do is seek dividend safety, which is typically measured by the dividend coverage ratio. The dividend coverage ratio is a metric that measures the number of times the company can pay cash dividends to its shareholders – if the stock dividend coverage ratio is high, then that company is likely a safe choice for dividend investing. You'll want to invest in companies that pay out 60% or less of their profits to shareholders. For example, a company that earns $100 million and pays out $30 million in dividends is a safer choice than a company with the same profit who pays out $90 million. Check that the company has a stable income and cash flow that ensures continued dividend payments.
High yields: A dividend yield is a calculation that determines how much money you will earn, i.e., your payment, for every dollar invested at the current price based on the current dividend rate. To calculate dividend yield, divide your cash dividend by the share price. When investing, you want to look at dividend-paying companies that have high yield rates, but use caution and avoid dividend traps. Look at other companies in the same industry and compare their dividend yields to make sure they are on a par. A company with a high dividend yield may seem like a good bet, but do your due diligence before investing – a high yield can sometimes indicate that a company is in financial trouble.
High dividend growth rate: With this strategy, investors buy stock in companies that are currently paying lower-than-average dividends, but are growing extremely quickly. This rapid growth usually means that, in five to 10 years, the company will be able to pay dividends that are equal to or higher than they would have paid out had they used a high yield approach.
Qualified dividend stocks: When investing in dividend stocks as a shareholder, look for dividends designated as "qualified." This can help you qualify for more tax benefits. Qualified dividend stocks are held for a longer time – at least 60 days – and generally get the benefit of lower tax rates. The IRS has two main requirements for a dividend to be considered qualified:
- It must have been paid by a U.S. corporation or by a qualifying foreign entity.
- The stock must have been owned for a minimum holding period – at least 60 days for common stocks and 90 days for preferred stocks.
Some types of dividends can never be considered qualified, even if they meet the two above requirements. There are
- Dividends paid by tax-exempt organizations
- Distributions of capital gains
- Dividends paid by credit unions
- Dividends paid by a company on shares held in an Employee Stock Ownership Plan (ESOP)
Industry health: This is an often-overlooked aspect of dividend investing, but it can mean the difference between a good investment and a bad one. Look at the industry's history and the current climate around it; for example, many investors speculate that healthcare services will boom in the next two or three decades as the large baby boomer generation ages and requires increased medical care. This means that healthcare stocks are likely to be more resilient than other stock types.
Dividend aristocrats: Many new dividend investors start with dividend aristocrats, or stocks that have paid and increased their dividends for 25 or more consecutive years. The list was started in 1989 and included 26 companies, and has since grown to include over 50 companies. Dividend aristocrats are a great starting point for burgeoning investors because they're an almost guaranteed safe bet, having proven that they have durable business models that are capable of sustaining and increasing their dividend payments over time.
How to decide if dividend investing is a good idea
Dividends are generally considered a sign of good financial health, both for you as the investor and for the company you are invested in. Creating an investing strategy where you invest in companies with a good quarterly dividend history can add stability to your portfolio, and can provide you with the opportunity to derive steady income and cushion stock price declines.
Dividend investing is a great way to build wealth through compounding, which provides you with more shares as your dividends are paid. Dividends are also very rarely decreased, so you'll have a stable and reliable income stream for as long as the company you've invested in can pay the dividends.
However, dividends are not a guarantee, and can be subject to certain company-related and economic risks. Furthermore, companies that pay dividends are generally not high-growth leaders, as growth companies tend to spend more of their hard-earned money on research and development, capital expansion, and employee retention than on stock dividends. In this case, traditional stocks might be a better option if you are looking to invest in high-growth companies.
It is also difficult – if not impossible – to make any significant money from dividends if you do not have significant money on hand to invest, and even then, it will take many years for you to see results. You must determine if investing is worth the risk in the stock market and if you are willing to wait to see a return on your investment.