Dividend investing for beginners 

As someone new to investing, you may come across terms like dividends and dividend investing. You may already be familiar with dividends, which are payments made to shareholders. Dividends can be paid out once a month, every quarter, or twice a year, depending on the company’s performance and cash flow.  

But what is dividend investing? How does it work and is it a good strategy? In this article, we discuss the nuances of dividend investing to help you decide if this is a good investment strategy for the long term.  

Introduction to dividend investing 

Investors who prioritize stability and consistent returns in the long-term may find that dividend investing can be a good strategy for their financial goals. One of the key advantages of dividend investing is the potential for both income generation and capital appreciation.  

How is this so? By investing in companies’ dividend-paying stock, investors not only benefit from regular cash payments, but they also get to take part in the growth of the company's stock price.  

Well-established companies that have a history of profitability and a strong financial position typically offer dividend-paying stocks. Investing in them provides investors with a sense of security, knowing that their money is in companies with a successful track record.  

Dividend investing can provide a hedge against inflation, as dividend payments often increase over time. This also helps preserve the individual investor’s purchasing power. 

Understanding dividends 

Dividends are payments that a company gives out to share profits with its shareholders. A dividend is one of the ways that an investor can receive a regular return from investing in a company’s stock. 

The company’s Board of Directors decides: 

• when to declare dividends to shareholders 
• what form the dividends take  

• how much in dividends to distribute 

Dividends are payments that aren’t restricted to cash. Here are the different types of dividends:  

• Stock dividend – instead of cash, some companies give out additional shares of stock. This can be good for shareholders since the stocks are not taxed until they are sold. The only drawback to a stock dividend is that issuing them can dilute or reduce the share price.  
• Cash dividend – the most common type of dividend, which is paid out by transferring cash to the shareholders. Cash dividends can be paid out quarterly, but it’s not uncommon for some companies to give cash dividends monthly, semi-annually, or even as a lump sum payment. 
• Liquidating dividend – this type of dividend is paid to shareholders when the company is liquidated. As the business is closed due to poor performance or bankruptcy, shareholders receive the amount they originally invested or contributed. This type of dividend is usually not taxed.  
• Property dividend – this is a less commonly used type, where shareholders receive company assets or inventory instead of cash or shares. The value of the property dividend is based on the fair market value of the asset; this in turn determines how much each shareholder receives. 
• Scrip dividend – this is essentially a promissory note for an upcoming cash dividend when a company does not have enough money to cover them. Shareholders are entitled to dividends later, and sometimes this comes with interest.  

Terms to remember 

When it comes to dividends and dividend investing, here are some basic terms to keep in mind:  

• Record date: when the company checks and records information on which shareholders are eligible for a dividend payout 
• Dividend yield: this is the annual dividend per share; it’s computed by dividing the upcoming dividend by the share price 
• Ex-dividend date: this is a cut-off date. If an investor buys shares on or after this date, they won’t receive the upcoming scheduled dividend 
• Declaration date: this is when a company’s board of directors formally announces a dividend payment. On the declaration date, shareholders can also learn about the dividend’s amount, ex-dividend date, and payment date 
• Payment date: the day on which declared dividends are distributed. If it’s a cash dividend, the company sends checks to shareholders or credits their brokerage accounts 

Benefits of dividend investing  

Investing in dividend stocks can offer a few interesting benefits. There are at least three compelling reasons for investing in dividend stocks:  

1. Dividend stocks offer near-guaranteed returns 

From 1936 to 2022, 40% of S&P 500 index’s total annual returns were composed of dividends. Dividend stocks also consistently outperformed the S&P 500 index and experienced less volatility. 

2. Dividend stocks are secure investments 

Companies that are consistent dividend payers are often well-established and profitable companies. In fact, companies like these are grouped into an exclusive club known as the dividend kings. They’re stocks that have increased dividends for at least 50 consecutive years.  

Conservative investors living off retirement accounts can do well with stocks of dividend kings or dividend aristocrats, at least.  

3. Dividend stocks can serve as buffers for market downturns 

In times of crisis that caused the S&P 500 to decline by 5% or more, investors with dividend stocks felt less of the impact. There have also been instances where dividends have beaten inflation, as in 1973, 1979, and during the early 1990s.  

Despite those periods of high inflation, dividend income growth surpassed 10%. Even during some stagnant periods in the 1970s, dividends reached as high as 10%.  

A good way to leverage dividend stocks is to combine them with an investment account like a Roth IRA. This video gives a good example: 

Another good strategy is to do a dividend reinvestment, buying more dividend stock for higher future dividends or at least having more stock to sell off later. The video shows that being creative with your investment can literally pay off dividends! 

Assessing dividend stocks  

While the case has been made to invest in dividend stocks, how do you know if a dividend stock is worth investing in? As dividends are taken from company profits, it usually follows that dividends are a good sign of a company’s financial health and the viability of its shares of stock. 

Buying stock from established companies with a long enough history of paying substantial dividends can add stability (apart from diversification) to your portfolio. When evaluating if a dividend stock is investment-worthy, there are four ratios you should look at:  

1. Dividend Payout Ratio 

This ratio indicates the portion of a company’s annual earnings per share that it pays in the form of cash dividends per share. This may also be seen as the percentage of net income paid as cash dividends.  

To compute the dividend payout ratio: 

total annual dividends per share (DPS) ÷ Earnings Per Share (EPS) 

or  

total dividends ÷ net income 

For instance, if a company, let’s assume XYZ Corp., declared dividends amounting to a total of $2 million and its net income for the year was $10 million. When dividing the $2 million in dividends by the $10 million profit, the resulting Dividend Payout Ratio is at 20%.  

This makes XYZ Corporation a good dividend stock to buy. A company that pays out less than 50% of its earnings in dividends means the company is both stable and has great long-term potential.  

On the other hand, a company that pays out over 50% of its net income as dividends may not increase its dividends as much or pay as often.  

Companies that have high dividend payout ratios can have problems paying out dividends in the long run. When evaluating a company’s dividend stock, investors should compare its dividend payout ratio with similar companies and/or its industry average.  

2. Free Cash Flow to Equity Ratio 

The Free Cash Flow to Equity (FCFE) Ratio is a measure of the amount of cash that can be given out to shareholders. This is a net amount after all operating expenses and debts have been paid.  

The FCFE ratio is calculated by deducting these from net income:  

• net capital expenses  
• debt payments 
• change in net working capital 

Any net debt is then added to the resulting amount. Simply put, the FCFE Ratio shows the amount of cash made by the company each year that is free of all internal or external debt.  

As an investor, you would want stock from a company with a good record of making dividend payments, coupled with a high FCFE ratio. That’s because companies with a high FCFE can buy back shares, increasing the value of the remaining shares.

3. Dividend Coverage Ratio 

When you divide a company’s annual Earnings Per Share (EPS) by its Dividends Per Share (DPS), that gives you its Dividend Coverage Ratio (DCR). Another way to get the Dividend Coverage Ratio is by dividing its net income, after subtracting required dividend payments to preferred shareholders.  

This ratio shows the number of times that a company can pay dividends to common shareholders with net income over a specific fiscal period. In terms of dividend stock, a company with a high DCR would be considered a good investment. 

In simpler terms, the DCR calculates how many times a company can pay dividends to shareholders with its net income. Also known as dividend cover, the DCR can also help investors estimate their risk of not receiving dividends. 

4. Net Debt to EBITDA Ratio 

Net debt to earnings before interest, taxes depreciation and amortization (EBITDA) Ratio measures a company’s leverage and ability to pay off debt.  

This is calculated by first deducting a company’s total cash and cash equivalents from its total liabilities, then dividing that amount by its EBITDA. A company that has a lower ratio than its industry average or competing firms in the same industry is generally considered a viable investment.  

In cases where a dividend-paying company’s net debt to EBITDA ratio is high and has been steadily increasing over time, that can be seen as a sign that it will soon cut its dividend.  

Dividend Stock Assessment Cheat Sheet 

What are the risks in dividend investing?  

You’ll see in our guide on investing for beginners that investments involve risk. Dividend investing is no exception. So, what are the risks involved? 

1. High-yield dividend stocks can be traps 

Stocks that give high dividend yields are known as dividend traps. As appealing as a dividend stock with high yields appears, this can be a sign of a future dividend reduction. When you notice a stock paying out a hefty dividend, don’t bite right away. Do your research and find out the stock yield’s underlying nature. 

Is it a real indication of profits? Or is it a way for a troubled company to bait investors to buy more of their stock and raise money quickly?  

2. There can be no link between stock dividends and business growth 

In general, a company may choose to cut dividends if it does not have a good cash flow to pay them.  

But this may not always be the case. Sometimes, a company’s board of directors can decide to reduce or cut dividends because they believe that their profits are better used for other purposes.  

Instead of paying dividends, the company can use the money for: 

• expanding  
• paying off debt 
• repurchasing its own stock 
• giving bonuses to directors 

Common stocks for shareholders are not legally required to pay dividends even if they have the profits to do so. Dividends are decided by the company’s board of directors, and they can always decide to cut dividends.  

3. You could lose out on massive gains 

Perhaps the biggest downside to investing in dividend stocks is the missed opportunity for huge gains. Even the most high-yielding dividend stock has a cap on its returns; no stock can give more than 10% annually.  

Investing in high-growth stock or mutual funds could be more profitable instead of in dividend stocks in this case. While high-growth stocks could have massive losses, they can also have massive gains.  

For instance, if an investor chose to invest in a lot of stocks in Apple or Google instead of dividend stocks, they would be very wealthy today. Investing in a lot of dividend stocks simply cannot lead to growth at a similar level.  

Even if a stock gives the highest dividends imaginable, it cannot offer the same total return of other growth investing strategies. Remember also that dividends can be reduced or cut at any time as the company grows.  

Dividend investing as part of a strategy 

As with most investment strategies, dividend investing has its share of advantages and disadvantages.   

While receiving regular payments from dividends is both enticing and beneficial, there is no guarantee that those companies will always pay dividends. There’s no guarantee of higher dividends either.  

Individual investors taking this route would benefit most if it’s part of their investment strategy and does not make up the bulk of their investments. 

Beginning investors can include a few dividend stocks but should diversify their portfolios with other investments like bonds, mutual funds, and exchange-traded funds. Consult a financial advisor and create a portfolio that suits your needs and financial goals.  

Check out our list of the top financial professionals in the US for the brightest names in the industry. Get in touch with any of them for advice on dividend investing and other strategies.