Reuben Gregg Brewer
(TMFReubenGBrewer)
Updated: Dec 2, 2019 at 2:59PM
Author Bio
Reuben Gregg Brewer believes dividends are a window
into a company's soul. He tries to invest in good souls.
Using dividend-paying stocks as the backbone of a
diversified portfolio is a wonderful thing. However,
those new to investing might have some questions
about dividends. But knowing what a dividend is and
how dividends work is only half the battle, since
knowing how to make the best use of dividends can set
you on the path to true financial freedom. Here's a
dividend investing guide that will provide you with a
basic understanding of what dividends are and help you
create your own dividend portfolio strategy.
Image source: Getty Images.
What is a dividend?
A stock investment is, at its core, a claim on the longterm stream of cash flows generated by a business, or
the money generated by the business. There are
different ways to benefit from these cash flows, with
the two main sources being an increase in stock prices
due to growth in the business, referred to as capital
appreciation, and cash distributions funded by the
ongoing cash flows the business generates. Dividends
are a form of cash distribution and represent a tangible
return that you can then use for other purposes.
A dividend-paying company is, essentially, writing a
check to its shareholders out of the profits it generates.
For investors who use a broker, which is most investors,
that check will simply be a deposit that shows up on
your brokerage statement. Dividends are generally paid
to shareholders at regular intervals, with quarterly
being the most frequent timing in the United States.
However, dividends can also be paid monthly,
semiannually, annually, and even on a one-off basis, in
the case of "special" dividends. (There's more
information on the frequency topic below.)
To help with the processing of dividends, there are a
few key dates to watch, most notably the ex-dividend
date, which is the first trading day on which a future
dividend payment isn't included in a stock's price. After
the ex-dividend date, a stock trades as if it has already
paid the dividend. If you buy the stock before that date,
you get the dividend. If you buy the stock after the exdividend date, you don't receive the dividend.
This all may sound a little complicated right now, but
after spending a little time understanding dividends,
you'll see that they're pretty easy to get your head
around. Despite their simplicity, however, they can have
a huge impact on your financial life. A real-world
example will probably help here. ExxonMobil
Corporation (NYSE:XOM) pays quarterly dividends in
March, June, September, and December. Between
January 1 of 2009 and December 31 of 2018, the
company's stock fell roughly 15%. But investors who
took those quarterly dividends and bought more Exxon
stock (known as reinvesting) would have achieved a
gain over the 10-year span of 15%. This is because they
were buying stock all along, increasing their investment
with the dividends they received.
Are dividends a good thing?
For some investors, dividends are great...for others,
dividends are a nuisance. In the end, whether you think
dividends are good or bad will really depend on your
investment approach and temperament. For example,
some investors use their dividends to supplement their
Social Security check during retirement. Such investors
love dividends. Other investors, those who wish to
avoid taxes or who are still building a nest egg, might
prefer to see a company reinvest all of its cash into the
business to spur higher levels of growth. Investors like
that might deem dividends a waste of cash.
Some investors might also prefer to see cash used to
buy back stock instead of pay dividends. Buying back
stock is another way in which companies can return
cash to shareholders without actually distributing the
money to shareholders. The ownership interest in a
company is spread across the total number of shares a
company issues. By reducing the number of shares
outstanding via a buyback, the company gets to spread
earnings over a smaller share base. So every share is
awarded a larger piece of the company's earnings,
which, in turn, increases earnings-per-share growth.
Since earnings are a key metric by which company
success is graded by investors, higher earnings generally
lead to higher share prices.
Some companies like to use share buybacks because
they don't actually have to complete buybacks even if
they announce them. This provides more flexibility in
case the business environment changes. Investors tend
to react poorly if dividend payments are reduced even if
a company is facing hard times.
How are dividends decided?
At the most basic level, the chief executive officer of a
company makes a recommendation to the board of
directors on what he or she believes is an appropriate
dividend policy. Often there is no specific public policy
to go off of, just the dividend history. But some
companies do make public their dividend goals. For
example, some companies target a percentage of
earnings or cash flow. Brookfield Renewable Partners,
for example, targets 70% of distributable cash flow, a
non-GAAP measure that shows how much cash it could
pay if it wanted to. That said, the intent is to keep
growing the dividend along with the partnership's
growth, so it will hover around that target over time.
You should check to see if a company has a stated
policy, but often you'll be stuck with nothing more than
the history.
It's important to note that the CEO isn't the one making
the final call here; the board of directors is. This
collection of individuals comprises the elected
representatives of the shareholders. They are
effectively the boss of the CEO and have the final say on
key issues, including how a company's profits should be
used. Dividends are a big piece of that story. So the
board takes the CEO's advice, discusses it, and votes on
what it believes the dividend should be. The types of
issues a board might look at include, but are not limited
to, the company's profitability, available cash, leverage,
and future capital needs.
A key issue to keep in mind here is that while a
company's earnings are an important consideration in
this process, dividends actually come out of cash flow.
Earnings are an accounting measure dictated by a
standard set of rules that try to tie revenues and
earnings to specific time periods. Cash going in and out
of the company, or cash flow, doesn't work the same
way. For example, a big capital investment like a truck
will be paid for when it is bought, reducing the cash a
company has the day it is acquired. But for earnings
purposes, the cost will get spread across the useful life
of the truck, since it is getting used a little bit each
quarter. This is called depreciation, and it has no impact
on cash flow, but it can be a notable issue for earnings.
Since dividends are paid out of and impact a company's
cash, with little to no impact on earnings, the cash flow
statement is where dividend payments are reflected.
This statement actually tracks the cash that is going in
and out of the company during a set period of time.
Going back to the truck example above, a company's
earnings may be lowered by depreciation expenses for
that expense for years, but the cash going in and out of
the company won't be impacted because the money
was already spent. So the cash a company has available
may actually be more in a given period than the
earnings a company reports. This helps explain how a
company can pay more in dividends than it earns, since
noncash charges, like depreciation, can lower earnings
while having little to no impact on the cash a business is
generating.
At the end of the day, the cash flow statement is closer
to how you might look at your own finances. While the
earnings statement is important, the cash flow
statement is the best way to see if a company can
actually afford the dividend it is paying.
Some key dividend dates
There are some important processing issues involved
when it comes to dividends, largely related to timing.
The first is the declaration date, which is when a
company announces its dividend plans to the market. In
this statement, in addition to the actual dividend
amount, it will report the record date, the ex-date, and
the payment date. To understand this process, it may
help to look at a real-life example.
On October 31, 2018, ExxonMobil put out a news
release informing investors and the public about its
intention to pay a fourth-quarter dividend of $0.82 per
share. That news release was the declaration of the
dividend. In addition to the amount, the company also
reported that the dividend would be paid on December
10 to shareholders of record as of November 13. The
payment date is the day on which shareholders will
receive the dividend. The record date is effectively the
day the company makes the list of all of its
shareholders.
The only date that wasn't included in the release was
the ex-dividend date, which is generally two business
days prior to the record date to account for the time
needed to clear stock transactions. (In this case, the exdividend date was November 9 because of a weekend.)
This date was not in the press release but was reported
on the company's website. Purchase the stock prior to
that date and you will be eligible for the dividend; buy
after the record date and the previous owner will get
the dividend. In effect, the ex-date is the specific date
on which the stock will trade without the dividend
included in the price.
For most investors, particularly those with a long-term
view, these dates will not be too big an issue. However,
if you are looking to buy a stock, you might want to
double-check the dates just in case. You'd rather get a
dividend than miss it by a day or two because you
procrastinated.
Some investors, meanwhile, try to capture dividends by
investing around these dates. Dividend capturing is a
strategy in which investors only hold stocks long enough
to receive the disbursement before moving on to
another stock. In this way, the investor can invest in
many dividend stocks with the same money and
"capture" more dividends. Although this sounds like a
great idea, it is complicated and time consuming.
There's another technicality that complicates the
dividend capture approach: Dividends are technically a
return of retained earnings (a balance sheet item). As
such, the stock price logically should fall by the amount
of the dividend once it hits the ex-dividend date.
There's also the risk that the stock price could be moved
by company news or events in the broader market
during the holding period. So you will generate income
from the dividend you collect, but you could end up
with an offsetting capital loss when you sell the shares.
It's very possible that the net benefit will be less than
you might hope, and thus, most investors shouldn't get
involved with dividend capturing.
Some key dividend metrics
Now that you've got the important dates to keep in
mind, you'll want to understand some of the key
metrics you'll see when researching dividend stocks.
The most prominent is the dividend yield. This is
generated by taking the most recent dividend payment
and multiplying it by the dividend frequency (how many
times a year the dividend is paid) and then dividing by
the current stock price.
The higher the yield the better for most income
investors, but only up to a point. Abnormally high yields
can indicate heightened levels of risk. A good reference
point for investors is to compare a stock's yield to that
of the S&P 500 Index to get a sense of whether it is high
or low, since market conditions can change over time.
Yields should also be compared to those of direct peers
to get a sense of how high or low a yield is, since some
industries tend to offer higher yields than others. Note
that some data services will provide a trailing dividend
yield, which takes historical dividends that were paid
(usually over the last 12 months) instead of looking at
the current dividend and multiplying by the frequency.
Another metric that investors focus on is the payout
ratio. This can be derived by taking the dividend and
dividing by the company's earnings per share. Although
dividends don't get paid out of earnings, this gives an
idea of how easily a company can afford its dividend.
The lower the payout ratio the better, with ratios over
100% worthy of additional research (noting that some
industries, such as real estate investment trusts, almost
always have payout ratios over 100% because of heavy
depreciation expenses). This figure can be calculated
over different time periods, but it is usually looked at
quarterly, over the trailing 12 months, or annually.
Some investors will also look at yield on purchase price.
You calculate yield on purchase price by taking the
current dividend per share and dividing it by your
average cost per share. This is a number that is,
obviously, specific to each individual investor. It is most
appropriate for investors who have owned a dividendpaying stock for a very long time and for those who
have used dollar-cost averaging to create their position.
For example, if you had purchased Microsoft
Corporation on the first business day of 1995 for $26.95
(the highest price on that day), the dividend was a scant
$0.32 per share per year, providing investors with a
roughly 1.2% dividend yield. By the end of 2018, the
dividend had grown to $1.68 per share per year. That's
a yield on purchase price of 6.2%!
How often are dividends paid?
Dividend yield and the payout ratio bring an element of
time into the dividend discussion. In the United States,
most companies pay four dividends a year, or one each
quarter. That, however, is just one option. Some
companies, like Realty Income, a real estate investment
trust, pay dividends monthly. (There aren't too many
monthly dividend stocks, which is a shame, since the
dividend checks from these companies end up closely
mimicking a regular paycheck, thus simplifying the
budgeting process for investors.) Others pay twice a
year, or semiannually. An example here would be
Disney, which pays in January and July. Many European
companies, meanwhile, only pay two times a year, with
one small interim payment followed by a larger "final"
payment. Most U.S. companies pay the same amount
each time. Some companies only pay one time a year,
such as Cintas, which tends to wait until near calendar
year-end to pay its annual dividend.
To properly figure out the dividend yield and payout
ratios of these companies, you need to take the
dividend frequency into consideration. Note that some
data services don't get this step right, leading to
erroneous data. So you should always go to a
company's website to double-check any dividend
statistic that seems unusual.
There's one more thing to keep in mind here as well.
Sometimes companies pay special dividends. These are
payments that are made outside of their typical
dividend schedule. An example is Kinder Morgan
Canada, which sold a large asset in 2018 and chose to
distribute a portion of the cash it generated to
shareholders via a one-time distribution. Such dividends
shouldn't be considered in the yield or payout ratio,
since they are unusual events. That said, some
companies have a history of paying special dividends on
a regular basis, like L Brands, though it hasn't done so
lately, showing that such extra payments shouldn't be
relied on.
Not all dividends are paid in cash
To complicate things even more, dividends aren't
always paid in cash. Sometimes a company pays a stock
dividend, through which it issues each investor
additional shares of the company. One great example is
Tootsie Roll Industries, which has a very small cash
dividend but also generally pays out a small stock
dividend each year. The net benefit for investors is that
the number of shares they own increases over time.
Other times, a spin-off is effected via a stock dividend in
a new company. This happens when a company gives
shareholders freshly created shares in one of its
operating divisions so that it can break the division off
as its own public company. One of the classic examples
of this was the 1984 breakup of AT&T, lovingly referred
to as Ma Bell, into a long-distance company of the same
name and seven so-called Baby Bells. The Baby Bells
owned the local telephone companies serving various
regions of the United States. For every 10 shares of
AT&T, investors received one share in each of the seven
regional phone companies. This move broke AT&T from
one company into eight.
All of that said, stock dividends are generally not the
norm, though a small number of companies do have
long histories of paying regular stock dividends.
What's a dividend cut?
So far so good, but dividends don't always go up.
Sometimes when a company is facing financial trouble,
it has to cut its dividend. Investors usually don't like
dividend cuts, as noted above, and will sell companies
that cut or that they believe are likely to cut. This is why
you need to use caution when looking at companies
with high yields and high payout ratios, as both could be
a sign that the current dividend isn't sustainable.
That said, some companies have variable dividends, so
their dividends are expected to go up and down over
time. Dividend changes at companies like this have to
be looked at differently because the dividend policy is
often more important than the dividend payment.
Wheaton Precious Metals is a good example here. The
company targets 30% of the average cash generated by
operating activities over the previous four quarters. And
it pays out exactly that amount, regardless of whether it
is more or less than the previous dividend. This is
noteworthy because Wheaton generates revenue by
selling precious metals, the prices of which can be
volatile.
What is a DRIP?
An acronym you'll frequently hear associated with
dividends is DRIP, which stands for dividend
reinvestment plan. Many companies allow you to buy
stock from them directly and then use the dividends to
automatically buy additional shares over time.
Sometimes companies offer incentives for this, such as
slightly-below-market reinvestment prices, and usually
these transactions will not incur brokerage trading fees.
A few companies require that you buy stock from a
third party and then transfer the shares to the
company's plan. The big deal here, however, is that you
are using the dividend to buy more shares. That's
basically dollar-cost averaging, or spreading your
purchases over time.
This is a service that many brokerages offer for free
today (without the incentive of below-market prices).
So you can often do the same thing without the need to
open and monitor multiple accounts with different
companies, which is what you would be left with if you
enrolled in multiple company-sponsored DRIP plans. If
you like to keep your life as simple as possible, ask your
broker if it offers free dividend reinvestment.
What are Dividend Kings,
Aristocrats, Champions,
Challengers, and Contenders?
Dividend investing is a big thing, and investors have
taken to using shorthand terms to describe dividend
companies. Kings, Aristocrats, Champions, Challengers,
and Contenders are some of the "in the know" terms
you'll want to be fluent with. Each represents a
different streak of annual dividend hikes:
Terms for Different Dividend-Paying Records
Dividend Kings
50+ years of annual dividend
increases
Dividend
25+ years of annual dividend
Aristocrats
increases
Dividend
25+ years of annual dividend
Champions
increases
Dividend
10 to 24 years of annual dividend
Challengers
increases
Dividend Achievers 10+ years of annual dividend
increases
Dividend
5 to 9 years of annual dividend
Contenders
increases
All of these terms are associated with longtime dividend
payers. Some are formal lists that are maintained by
companies like Standard & Poor's (and used to create
investment products like exchange-traded funds, or
ETFs ), while others are informal lists maintained by
volunteers and available for free at websites like The
DRiP Investing Resource Center.
Lists such as these are a great starting point when
looking for dividend stocks, since companies with a long
history of increasing dividends have proven that they
place a high value on rewarding investors.
What is a dividend trap?
A dividend trap is yet another term you'll hear to
describe a dividend stock, only this one isn't positive at
all. Essentially, a dividend trap is a stock with a high
yield backed by a dividend that looks unsustainable. A
good example here is rural telecom Frontier
Communications (NASDAQ:FTR). In 2017, the company
paid four quarterly dividends of $0.60 per share despite
the fact that it was bleeding red ink the entire time.
With no earnings, its dividend coverage ratio was
actually negative. Its business had been struggling for
some time under the weight of deteriorating financial
results and a heavy debt load left behind from
acquisitions.
The company ended up eliminating the dividend in
2018. However, as 2017 progressed, the dividend yield
went from around 10% or so to an unbelievable 50% as
the stock plummeted from more than $50 per share to
roughly $6.75. A yield of 10% is high and deserves extra
attention, particularly at a highly leveraged moneylosing company. But a yield of 50% is completely
ridiculous -- the stock market was sending a very loud
warning signal. Before you jump on a fat dividend yield,
make sure you do a little digging to ensure that the high
yield isn't a result of material financial troubles and,
equally important, a high likelihood of a dividend cut.
You want to do your best to avoid dividend traps like
Frontier.
Do dividends tell you anything
about valuation?
Often investors look at a price-to-earnings ratio to see if
a stock is trading cheaply or richly. P/E is just price
divided by earnings, much like a dividend yield is simply
dividend payment divided by stock price. They are both
relative measures. P/E tells you how much investors are
willing to pay for each dollar a company earns, and
dividend yield, roughly, tells you the level of income
generation investors expect from a company over time.
Truth be told, on their own, P/E and dividend yield don't
tell you all that much about valuation. However, when
you compare them to a company's own history or to a
broader group (like an index or direct industry peers),
you can start to see valuation patterns. For example,
Hormel Foods' dividend spiked above 2% in late 2017,
toward the high end of the company's historical yield
range. Its P/E at the time was around 19, having fallen
from more than 30 in early 2016. Essentially, the
dividend yield was telling a similar story to the P/E ratio.
There are usually reasons why companies trade with
low valuations; in this case, a shift in consumer buying
habits toward fresh food over the prepackaged fare that
dominated Hormel's portfolio had spooked Wall Street.
But for long-term investors, a high relative dividend
yield can be a buying opportunity. Hormel, for
reference, started to shift its business mix via
acquisitions that augmented its scale in fresh
categories, notably including the deli aisle. By the end of
2018, Hormel's yield was roughly 1.8% and the P/E was
back up to around 22.
Dividend taxes: Uncle Sam gets
his due
No discussion of dividends would be complete without
mentioning taxes. The government wants to get its due
of these payments. You will receive tax forms from your
broker or DRIP plan that outline what dividends you
have received in a given year, and that information
must be included in your income when you do taxes.
That said, tax laws change over time, so the tax rate
you'll pay on dividend income will vary. Dividends often
receive preferential tax treatment. All dividends,
meanwhile, are not created equal. Some companies
include return of capital in their dividends. Such
dividends are considered a return of a portion of your
original investment and don't get taxed when you
receive them. They reduce your cost basis when you
sell, thus increasing your capital gains (which is the
difference between what you paid for an investment
and what you sold it for, assuming you made a profit on
the transaction).
Other companies, notably real estate investment trusts,
are structured as pass-through entities because they
pass much of their income to investors in exchange for
avoiding corporate-level taxation. Most if not all of the
dividends they pay are treated as regular income -- just
like your salary. These types of dividends are often
referred to as unqualified.
Qualified dividends, meanwhile, are the norm. This type
of dividend is paid by most U.S. companies and gets
taxed at special rates. As an example, in 2018, qualified
dividends paid to a couple filing jointly with earnings
less than $77,200 a year don't get taxed at all. Such a
couple making less than $479,000 but more than
$77,200 would see their dividends taxed at a 15% rate.
And a couple making more than $479,000 a year would
see a dividend tax rate of 20%.
Taxes are a complex topic, and you should consult an
accountant for an in-depth discussion here. But rest
assured that you need to let Uncle Sam know about
your dividends, or the IRS will be sure to hunt you down
and extract its pound of flesh.
That said, there's a workaround on the tax front if you
really don't want to pay taxes on your dividends: a Roth
IRA. Like taxes, retirement accounts are complex, and a
full discussion is beyond the scope of this article. But a
Roth IRA is funded with money on which you have
already paid taxes, and distributions in retirement are
tax-free. So if you put dividend stocks into a Roth IRA,
you would, effectively, be generating tax-free income.
This is not the case for a traditional IRA, which is funded
with pre-tax earnings...in this case, every penny you pull
out is taxed as income. If the idea of using a Roth IRA to
generate tax-free income sounds enticing, it's probably
worth taking the time to talk to your accountant.
--
Scott Harrington
desergiant@gmail.com