If you want to grow your investments over time, it's a good idea to understand the dividend growth model, starting with the question ‘What is a dividend’?
When most people think of the stock market, they imagine what they’ve seen on movies and television shows; a room full of people frantically shouting instructions to buy or sell with fortunes on the line. As so often happens, the reality is much less dramatic.
While the headlines sensationalize the big rollers that managed to get lucky, the real winners aren’t shouting, they’re too busy doing math. One of the safest ways to make money investing in stocks is to have a growth plan that reinvests your earnings from dividends over time to maximize profit. This statement should leave you asking "What is a dividend?"
To answer the question, you have to remember that when you're investing in the stock market, you aren’t just riding profit and loss trends, you're actually buying portions of a company. When the company you own a part of turns a profit, the profit can be reinvested in the health of the business or divided between the shareholders. Most businesses will do a combination of the two, depending upon their financial outlook.
When a portion of a company’s profit is paid out to shareholders, it is called a dividend. This is one way that your investments can make money for you, and what you choose to do with your dividends can have a dramatic impact on the outcome of your investing strategy.
How dividends work
When you buy stock in a company, you have two rights. These are the right to participate in electing the board of directors, and the right to a portion of the profits that the company makes. The allocation of the profits between reinvestment in the company, and payout in the form of dividends, is handled by the board of directors.
To be clear, the full value of that profit will still benefit your portfolio even if it isn’t paid directly to you as a dividend. The more profitable the company is, the more valuable your stock in that company will be on the market, improving your portfolio. Reinvesting that profit in the company should, in theory, generate future profits.
When a company pays dividends to its shareholders, it can actually have an indirect impact on the value of the stock. After the record date, which is the date the board of directors has indicated that the dividends are to be paid, the stock will open at a devalued ex-dividend state. Because so much of investing is about interpretation, when a company announces a dividend payout, it can change how the stock is valued on the market, which can affect the value of your portfolio.
When you do receive a dividend payment, there are two ways you can choose to use the funds. You can simply keep the money as a payout, or you can use the funds to buy more shares in the company. The decision of whether to use dividend-generating stocks to grow your investments or as a means of payout is a strategic one, which will be based on your needs as an investor.
Types of dividends
There are three different types of dividends and they're used in different kinds of situations.
- Cash dividends: These are the most common types of dividends, a direct payment of money to the shareholder.
- Stock dividends: The board of directors can also choose to pay dividends in the form of shares. Depending upon the size of the stock dividend payout, you can receive whole or partial shares for each share that you currently hold.
- Extraordinary dividend: This is the allocation of reserve cash to shareholders. These kinds of dividends are used to respond to external changes such as changes in tax rates that would make holding the money disadvantageous.
The decision to use these different kinds of dividends is strategic on the part of the board of directors, and you should consider the history of dividends that a company has paid when choosing whether to invest. This history will help you decide what is a dividend-producing stock’s value to your portfolio.
Understanding the pros and cons of dividends
As alluded to, the decision to distribute dividends is strategic, and that means it's about balancing advantages and disadvantages. In order to properly evaluate a company that regularly distributes cash dividends, you need to know what the pros and cons are, and why the board of directors is making the choices they are.
- The pros of dividends: Obviously, it’s nice to have a resource that sends you regular money! The payment of dividends is taxed lower than many other forms of income, so dividends are a more profitable way to make money from your investments. It’s also worth mentioning that a company that's able to turn a regular profit and distribute dividends is probably a strong and healthy company, making it a safer investment.
- The cons of dividends: Because dividends are compared to other interest-generating securities like bonds or CDs, the perceived value of dividend stocks can change depending on changes in interest rates. When other investment opportunities start to return at better rates, there is less excitement over dividends and the value of these stocks can drop. Additionally, a company that regularly distributes dividends may not be making the best use of their profits and may be limiting their potential growth.
So, investing in dividend producing stocks isn’t as simple as just looking at how big the distributions have been historically, it’s about evaluating the company and the kinds of decisions being made by the board of directors.
Investing in dividends
The decision to invest in dividend producing stocks can be driven by many things. When you build your stock portfolio, you're trying to address several needs, ranging from risk management through diversity of investment types, to your age and when you need to have access to your money.
When you're choosing the kinds of dividend stocks to include in your portfolio, you should consider factors like:
- Dividend coverage ratio: The dividend coverage ratio is a measure of the percentage of profit a company allocates to dividend payouts. It's used to estimate the security of the dividend: How much of a loss in profit could the company suffer and still be able to make the dividend payment? A rule of thumb is that you don’t want to see more than 60 percent of profits allocated to dividend payments.
- Dividend yield vs. dividend growth rate: This is an important distinction, and one that comes down to what is a dividend worth to you. A company with a high dividend yield will provide you with larger payouts and will make more sense in an interest-producing portfolio, while a high growth rate will have smaller payouts and make more sense in a portfolio focused on longer-term growth.
- Qualified vs. margin account: When you invest through a brokerage, you have the option to choose a cash or margin account. Much like a bank doesn’t physically hold your money, but lends it out to make additional interest, a margin account allows the brokerage to use your real shares for its own purposes. You don’t technically own the stock, but the brokerage is accountable to you for any profit that would be made if you did. While the brokerage allows you more flexibility for choosing a margin account, one of the problems with them are dividends. Taxable income from dividends only includes qualified payments, and not the equivalent funds provided by the brokerage for a margin account. If you want to enjoy the lower tax rates for dividends, buy them with a cash account!
Dividend stocks support long-term growth strategies, rewarding investors for holding stocks over a time. If you want a stable portfolio that will produce enough interest and profit to support your lifestyle without much meddling, regular dividends are a low-tax means of accessing that profit.
As you start to dig deeper into the world of investing, you're inevitably going to run into things you don’t know. When you have finance questions like "What is a dividend?", the Experts on JustAnswer can be an invaluable source of fast and affordable information. Rather than waiting for a scheduled visit with your financial advisor, you can get responses from verified experts in minutes.
Do you have any advice for dividend investing? Share them in the comments!