Dividend-paying stocks have long been a part of investment portfolios geared toward providing income instead of long-term capital appreciation. But since companies that pay big dividends are often older, more established firms, they fail to garner the same attention as the latest high-flying growth stocks.
Stocks that pay dividends are still a crucial part of an investment strategy, especially if you’re looking for consistent income. While the price appreciation might lag the broader market, dividend-paying firms have established profits and are usually safer investments than risky growth stocks. Still, a healthy dividend isn’t a golden ticket to wealth and investors must pay close attention to the underlying numbers of the business. A big dividend combined with poor cash flow or large debt loads could end up as a very poor investment.
Overview: Dividend Paying Stocks
When a company makes a profit, it doesn’t just sit in the pockets of the CEO. When profits are announced, the company board has to decide what to do with the extra cash. Many companies reinvest the money into research or development to continue growing the firm, but some companies aren’t concerned with expansion or entering new markets.
When a company doesn’t have an internal use for its leftover profits, it will return those profits to shareholders in the form of a dividend. Most dividend-paying firms disperse dividend payments each quarter and you need to own the stock by the “ex-dividend date” to make yourself eligible for the payment.
Dividend calculations take in a number of factors, such as:
- Sales growth projections
- Plans for expansion
- Average dividend yield in the sector
- Debt levels
- Current and future cash flow
Be cautious of companies offering dividends that seem too good to be true. A stock with a 10% dividend might have just endured a steep price decline that makes the dividend yield look more attractive. Kinder Morgan is a popular example: After piling on too much debt, the pipeline company was forced to slash its dividend by 75%, and the stock was crushed as a result.
Be sure to differentiate between ordinary dividends and qualified dividends as well. Ordinary dividends are taxed at the income level while qualified dividends are taxed at the capital gains level. For your dividends to be considered qualified dividends, you must hold the shares for at least 60 days. If you’ve held the shares for less than 60 days, you’ll receive the same dividend, but it will be taxed as income.
Best Online Brokers for Dividend-Paying Stocks
Dividend-paying stocks aren’t difficult to find since they often have long histories and popular stories. Since dividend-paying stocks are meant for long-term investing instead of short-term trading, finding a commission-free broker isn’t as crucial since you won’t be racking up transaction costs.
Still, if you can avoid the temptation to overtrade, a commission-free discount broker is suitable for both investors with long time horizons and investors looking to day or swing trade.
Features to Look for in Dividend Paying Stocks
- Manageable debt load: Like with Kinder Morgan, an unsustainable debt load could spell the end of a generous dividend. If a company is overleveraged and forced to service debts, the dividend is often the first thing on the chopping block.
- Dividend payout growth: Since stock prices can gyrate wildly, paying attention to the dividend yield doesn’t give us as much information as the actual payout amount. Keep a close eye on the growth of the dividend payment itself; if a company has a long history of increasing dividend payouts (10-20 years), it’s probably a good bet that it will continue to increase.
- Enough cash flow to keep paying: This is perhaps the most important feature of any stock, let alone a dividend payer. Cash flow is king and without it, no company would be able to continue to pay its dividend. If a company you’re looking at has consistent cash flow concerns, it could mean the dividend is in trouble of being chopped.
Dividends Provide Steady Income
Dividend-paying stocks are a great addition to portfolios because they’re often less risky than growth stocks. If you’re an investor approaching the end of your time horizon, dividend-paying stocks can provide steady income AND longer-term stock price appreciation.
But dividends aren’t free and tax implications exist for different types. Qualified dividends get special tax treatment like capital gains, but ordinary dividends are taxed at the income level. If you’re receiving ordinary dividends, a tax-sheltered account like a Roth IRA is the best vehicle.
Be sure to discuss taxes with an advisor before putting dividend-paying stocks into an investment account. Understand that dividend stocks aren’t going to make big headlines or double in price in just 6 months. If you want to buy dividend stocks, you’ll need to hold them long enough to benefit from the consistent dividend payout increases.