Imagine this: every few months, a slice of profit from some of the biggest and most successful companies lands in your account…just for being an investor. That’s the beauty of dividend investing.
But dividend investing isn’t just about receiving regular cash payments; it’s about building a portfolio that grows as the companies you invest in grow, providing financial stability and a path toward your long-term goals.
So, what exactly is dividend investing, and what are the pros and cons of this strategy?
What Is Dividend Investing?
Dividend investing involves buying shares in companies that pay dividends (cash distributions to shareholders as a reward for their investment). Investors who use this strategy do so to generate regular income rather than focusing entirely on capital appreciation (stocks going up).
The amount of dividends an investor receives depends on two main factors: the company’s dividend yield (more on this here) and the number of shares owned.
Concerning the second point, dividends are paid on a per-share basis. So, if a company pays £5 per share in dividends and an investor owns one share, their total dividend receipts will be £5. If they own 20 shares, their dividend receipts will total £100.
Types of Dividends
Dividends are paid from a company’s retained earnings (accumulated profits) and can be of different kinds. Some include the following.
Cash Dividends
As the name suggests, these are cash payments made to shareholders. Cash dividends are the most common type.
Stock Dividends
Instead of cash distributions, companies can reward shareholders with additional shares of stock. These shares don’t increase the shareholders’ ownership stake in the company but do increase the number of shares they own.
Special Dividends
These are usually one-off distributions, either in cash or additional shares. Special dividends are paid, for example, when a company has excess cash or sells a business asset.
Dividend Investing Ratios
Most financial metrics can be applied across investment strategies, whether value investing, growth investing or dividend investing. However, the following metrics (not an exhaustive list) are unique to dividend-paying assets.
Dividend Yield
As the name suggests, the dividend yield tells investors how much one share of a company’s stock yields in dividends.
Calculated by dividing a company’s annual dividend per share by its stock price, the dividend yield tells investors how much cash flow (in dividends) they’ll receive relative to the stock’s price. A 5% dividend yield on a £100 stock means £5 will be returned to the shareholder.
The higher the dividend yield, the higher the dividend payment. While this may sound attractive, high dividend yields often conflict with a company’s dividend payout and coverage ratios.
Dividend Payout Ratio
The dividend payout ratio tells investors what percentage of a company’s profit is distributed to shareholders. Calculated by dividing the total annual dividend payment by the company’s net profit, the metric indicates the sustainability of the dividend.
If an investor’s sole aim is to receive steady investment income, the dividend payout ratio is an essential metric to look for.
A high dividend payout ratio means the company distributes most of its profits as dividends to shareholders. Though this may sound like music to the ears, you must ask yourself, ‘Is this sustainable? Can [insert company name] sustainably reward shareholders with 80-90% of its profits each year into the foreseeable future?’
And here is where the dividend yield and dividend payout ratio can conflict.
While a high dividend yield means a higher amount of dividends received (per share), in most cases, a high dividend yield coincides with a high dividend payout ratio. Some companies can manage these high yields and payout ratios, but not all can.
All it takes is one bad year for the company, and the dividend can be cut or suspended. So, you go from receiving high dividend payments to lower dividend payments or no payments at all.
Dividend Coverage Ratio
While the dividend payout ratio assesses sustainability, the dividend coverage ratio evaluates affordability.
Calculated by dividing the company’s net profit by its declared total annual dividend, investors can answer the question: Can a company afford the dividend it’s about to pay?
Usually expressed as a multiple (e.g. 2x or two times), the dividend coverage ratio tells investors how much times the company’s annual profit can pay for the declared dividend. A 3x dividend coverage ratio means the company’s net profit can pay for its declared dividend three times over.
Like the dividend payout ratio, checking for the company’s dividend coverage is essential, especially when looking for steady investment income. High dividend yields can be initially attractive, but ensuring a company can afford the dividend is vital.
Dividend Investing Advantages
Dividend investing offers several benefits, making it popular among investors seeking income and stability in their portfolios.
Here are some of them.
Recurring Investment Income
Because dividends are cash distributions from a company’s profits, dividend investing provides regular income for investors.
With recurring dividend payments, investors can receive cash without selling any shares. They can use the dividends they receive to reinvest in the company that rewarded them, buy shares in other companies or withdraw for personal spending.
Compounding Potential
As alluded to in the above advantage, investors can reinvest their dividends for further growth.
Investors can increase their future dividend receipts without requiring additional personal funds by using dividends to grow their current share count. Because they’re reinvesting the proceeds (the dividends) from their initial investment, it’s as if they’re investing ‘free’ money.
The more dividends you reinvest, the higher your dividend receipts and the more ‘free’ money you can reinvest. As this cycle continues, investors steadily increase their share count, leading to compounding returns.
Lower Volatility
Most dividend-paying companies are well-established and financially stable. This makes them less volatile than, say, a young growth company.
Because of this characteristic, dividend-paying stocks are often a popular choice for conservative investors. They can sit back and collect their regular dividend payments in relative peace (they don’t have to be concerned with wild price swings).
Dividend Investing Disadvantages
Like all investing strategies, there are downsides. So, here are a few for dividend investing.
Reduced/Suspended Dividend Payments
When a company encounters financial hardship, it may cut or suspend its dividend, leading to a loss of regular investment income. These hard times can be self-inflicted (poor management decisions) or economy-related (recession).
If you’re investing for regular investment income, ensure the company can afford and sustain its dividend payments.
Limited Capital Appreciation
Limited capital appreciation is often a downside when investing in dividend-paying companies.
Dividend-paying companies are usually mature companies with minimal future growth. They will continue to grow, but not as much or as fast as their high-growth counterparts (technology companies, for example).
As compensation for their little growth, dividend-paying companies typically have high dividend payout ratios. While these companies may provide steady investment income, these receipts might come at the expense of the higher potential returns from high-growth companies.
Dividend Traps
A ‘dividend trap’ occurs when a stock has a high dividend yield, making it attractive to income-focused investors. However, the high yield is due to a declining stock price and not a robust dividend policy.
These dividend trap scenarios can cause the already beaten-down stock to fall further as existing shareholders sell their shares. The falling share price eventually negates the benefits of the higher dividend for those still invested – the investment losses may trump the dividends received.
Is Dividend Investing For Me?
If you are looking for steady investment income, then dividend investing may be for you.
Like with all investing strategies, research is fundamental. Understanding the company’s financial position and ability to cover and sustainably pay its dividend is paramount.
The more informed you are, the better your decisions.
Summary
Dividend investing is a way to supplement your income through the stock market. However, receiving a notable dividend takes time and money since the number of shares an investor owns dictates the amount of dividends they receive.
Before investing in a dividend-paying company, investors should assess its dividend yield (how much dividends each share yields), dividend coverage ratio (can the company afford the dividend?) and dividend payout ratio (is the dividend sustainable?), alongside other investing metrics.
While the advantages of dividend investing include recurring investment income, lower volatility and compounding potential, there are risks. The company may reduce or suspend its dividend, you may forego higher potential returns due to prioritising regular investment income, or you may fall prey to dividend traps.
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