Dividend investing is a tried-and-true method of wealth accumulation that offers inflation protection in a way that bonds do not. But finding top-notch dividend-paying companies can be a challenge.
Dividend investors need to do their homework to identify the companies that have healthy enough profits to sustain dividend payments year after year.
Key Takeaways
- Dividend investing is a reliable method of wealth accumulation that offers the inflation protection bonds don't have.
- Dividend investors should seek out companies with long-term profitability and earnings growth expectations between 5% and 15%.
- Companies should boast the cash flow generation necessary to support their dividend-payment programs.
- Investors should avoid companies with debt-to-equity ratios higher than 2.00.
- Beyond studying a company's fundamentals, investors should follow broader sector trends to make sure their chosen companies are positioned to thrive in the future.
Ex-Dividend Date Defined
The ex-dividend date is the first day on which new buyers of a stock will not be eligible to receive a dividend. The dividend for that period will be paid to the previous owner.
Strong Cash, Low Earnings Expectations
When vetting dividend-paying companies, long-term profitability is a key consideration. Any company can occasionally experience a profitable quarter. Only those that have demonstrated consistent annual growth should make the cut.
Specifically, investors should seek companies whose long-term earnings growth expectations range between 5% and 15%. Higher numbers are not necessarily good. Companies whose growth exceeds 15% tend to experience occasional earnings disappointments, which almost always nick the stock price.
Next, investors should strive to find companies with healthy cash flow generation, which is needed to pay those dividends.
Finally, a minimal five-year track record of strong dividend payouts signals continued dividend growth.
Of course, it's essential for investors to purchase their shares prior to the ex-dividend date.
Steer Away from Debt
Investors should avoid dividend-paying companies that are saddled with excessive debt. Companies with debt are forced to channel their funds into paying it off rather than committing that capital to their dividend payment programs.
For this reason, investors should examine a company's debt-to-equity ratio. If that figure is north of 2.00, move on.
Check Sector Trends
While scrutinizing a company's numbers is key, it's no less essential to look at the broader sector, to cultivate a more holistic projection of future performance.
Case in point: an oil company may be thriving this year, but a plunge in oil prices can cause its stock price to dive, meaning less cash is available for dividend payouts.
Be mindful of the big trends that drive economic sectors. For example, the aging baby boomer population inevitably will boost demand for healthcare services over the next several decades. This paves the way for steady dividend increases moving forward.
Or consider the soft drink industry, which has historically been a safe bet. Consumers are becoming increasingly health-conscious. Most major beverage companies are pivoting to healthier drinks. But this shift will take time and money that might be diverted from dividend payments.
What Is a Dividend?
A dividend is a shareholder's share of the issuing company's profit from the latest quarter or year. The company's board of directors votes on whether to issue a dividend and how much to pay, based on the company's profitability and the amount of cash it has generated.
Not all companies pay dividends. Those that do are mostly healthy, mature companies.
Dividends are paid on a per-share basis. For example, Coca-Cola, a famously steady dividend payer, paid a dividend of 0.46 cents per share in September 2023. The company had an annual dividend yield of 3.15% per share in 2023.
Are Dividend Payments Taxed?
Yes. There are two distinct tax rates for dividends.
"Qualified" dividends are treated as investment income, and are taxed at the capital gains rate of 0%, 15%, or 20%, depending on your tax bracket. Most U.S. corporate dividends fall into this category.
"Non-qualified" dividends are taxed at the income tax rate you pay, which may be 10% to 24% depending on your tax bracket. Some foreign company dividends fall into this category.
Taxpayers who receive dividends must report it on IRS Form 1099-DIV, Dividends and Distributions. The total is then transferred to line 3a of Form 1040.
Is There a Downside to Dividends?
It's hard to find a downside to a bonus, and that's what a dividend is. Dividends are paid only by profitable and stable companies. They are not generally paid by the fastest-growing young companies whose stock prices are soaring. Dividends are a reward to shareholders for holding onto a stock long-term rather than flipping it for a quick profit.
The Bottom Line
If you plan to invest in dividend stocks, look for companies that boast long-term expected earnings growth between 5% and 15%, strong cash flows, low debt-to-equity ratios, and competitive strength moving forward.
