Everything You Need To Know About Dividends and How Dividends Work- Your Ultimate Guide to Dividend Investing

Introduction

The whole idea of investing in dividends could be so lucrative. You might have had friends or relatives who have invested in dividend stocks and are making an excellent harvest from it. However, just like many aspiring investors, you do not have a clue of what dividends are, how they work, how to find the best dividend stocks, or how to evaluate dividends. So, you are at crossroads because, even though you want to invest in dividend stocks, you do not have the requisite knowledge of how to do so.


If you are the person described above, then you do not have to be worried anymore. This article will take you through the basics of dividend investing. It is your perfect companion to your journey of dividend investing. So have your seatbelts on, sit back and relax and let this article drive you through the roads of dividend investing.

What is a Dividend?

Companies are owned by shareholders who contribute capital (through stock purchases) to fund the operation of a company. As the owners of a company, shareholders are entitled to the share of retained earnings and profits that the company realizes. Upon generation of a profit or accumulation of retained earnings, the company can either choose to plough back the profits to the business, or the profits can be paid out to the shareholders. The paid-out portion of the profits to the shareholders is what is referred to as dividends.

Investopedia defines dividends as: "A dividend is the distribution of some of a company's earnings to a class of its shareholders, as determined by the company's board of directors. Common shareholders of dividend-paying companies are typically eligible as long as they own the stock before the ex-dividend

date."

What is Dividend Investing?

Dividend investing works like any form of investment. You purchase a stock or asset with anticipation that the asset will yield a steady flow of income. So, How do dividends work?

Dividend investing works by an investor purchasing stocks of a company that pays dividends so as to receive a regular income flow from the investment. As the stocks and portfolio increase in value, so do the revenues you will receive in dividends.

Purchasing stocks that pay dividends could be a very rewarding investment idea. However, like any investment project, dividend investing requires that you make smart decisions. Later on, we will learn a few smart dividend investment tips.

Why Invest in Dividends?

The following are the real benefits that come with income investment:

1. Steady Growth of Profits

One of the vital advantages of investing in dividends is that dividends grow steadily with time. Established corporates tend to increase their dividends rates from year to year. Mostly, companies do so to attract more investors. Companies that have steadily increased their dividends payouts for more than twenty-five years are referred to as Dividend Aristocrats. For instance, as of July 17, 2021, the S&P Global index had a compounded annual growth rate (CAGR) of  2.23%.  Such growth rates play to the investors' advantage.


For your safety, I will recommend that you only work with dividend aristocrats. Even though there might be a chance that the dividend aristocrat will decide not to increase its payout ratio, the chances are that you will see an increase in payouts in the years to follow.

2. Dividends Play a Great Role In Equity Valuation and Stock Selection

Investors often overlook dividends' impact on the Return On Investment, equity evaluation, and stock selection. Stock valuation using dividends has proved to be a reliable equity valuation technique.

Most financial analysts rely on valuation metrics that depend upon financial statements figures. This poses an accuracy problem, especially in a situation where accountants have manipulated the figures. Dividends, on the other hand, give a robust indication of the general well-being of a company.

3. Tax Benefits

The taxman treats dividends with some extend of leniency, making dividends a tax-efficient method of income and wealth generation. Dividends are taxed at lower tax rates than normal incomes, such as employment income and rental income. Check out the table below to discover how qualified dividends tax rates compare with the ordinary tax rates.

4. Preservation of the Purchasing Power of Capital


Dividends also help to preserve the purchasing power of capital. As you might be aware, inflation has a negative impact on investment returns. Thus, for you to realize a genuine gain from your pool of investments, the investment must provide enough return to shield the impacts caused by inflation.

Check out this scenario: You have purchased a stock whose value appreciates by 3% over one year. However, the inflation rates are working against you at a rate of 4% per annum. It means that you have actually made a 1% loss at the year-end even though your investment earned a positive increment.

Assuming the same stock that increased by 3% gives an additional 3% dividend yield, even with the prevailing inflation rates of 4%, the investment will still give a profit of 2%.

Types of Dividends

There are two major reasons why companies pay out dividends:


  • To increase investors' faith in the company
  • To show investors that the company is optimistic about the future


While paying out the dividends for the two reasons mentioned above,  the management decides the frequency with which the company will pay out dividends. The frequency can either be annually, semi-annually, quarterly or monthly. The company can choose to pay out dividends in various ways depending on the company's dividend policies. The following are the various dividends options that the company can choose to work with.

1. Cash Dividends

Cash dividends are no doubt the most common form that companies use to pay out dividends. The company deposits money in the shareholders' bank accounts

2. Script Dividends

Sometimes, companies might not have enough funds to pay shareholders their dividends. As such, the company might opt to give shareholders promissory notes as an assurance that the dividends will be paid at a specified future date. This results in what is technically referred to as notes payable.

3. Property Dividends

Companies can also choose to issue nonmonetary dividends in the form of property. The paid-out property dividend is evaluated against the prevailing market price of the issued asset.

4. Stock Dividends

Stock dividend is another popular dividend payout form. Here, instead of the company paying cash to the shareholders, the company gives additional shares of stock to the shareholders. Note that if a company issue less than 25% of previously issued stock, the 25% is treated as stock dividends. This works under the Dividend Reinvestment Plan (DRIP), where shareholders can reinvest their dividends, often at a discount.

5. Liquidating Dividends

Whenever the management board decides to return shareholders' initial stock investment, the funds given to investors are referred to as liquidating dividends. Often, this happens as a result of the plan to wound up the business.

What are Some of the Things to Consider When Investing in Dividends

Many people invest in dividends with the hope to receive healthy and growing revenues. In the prevailing environment of ultra-low interest rates, dividends are one of the few investment avenues that offer low-hanging fruits of investments. However, like every investment opportunity, dividend investing come with risks. Some factors, when overlooked, can come back to haunt you. The following are some of the factors that you must consider when investing in dividends.

1. The Competitive Edge

Before purchasing company stocks, it is wise to analyze the company to ensure that it has a sustainable competitive advantage. The competitive advantage should be strong enough to sustain the company for a long time. By competitive advantage, I mean that the company should be able to protect its market share from competing firms and not be at the risk of disruptive external factors.

2. Dividend Coverage

One of the critical elements of a dividend is its coverage. Before choosing a stock, you must see in it a solid cover to ensure a reasonable safety margin and the ability of the company to pay off the dividends year after year. You can check out the sustainability of stock by calculating its earnings per share.

3. The Balance Sheet

You must evaluate a company's financial position to see if it can maintain a sustainable and reliable dividend payout. A financially secure company will have the muscles to pay out dividends to shareholders without straining its equity financing. For instance, you can check how the company debt compares with its Earnings Before Interest, Taxes, Depreciation, and Amortization. You can also find out the proportion of assets that are funded by debt.

4. The Dividend Policies

Before buying stocks of a given company, ensure that you go through their dividend policies. Only buy their stock if their policies are favorable.

5. Macroeconomic Factors

It is also wise to look at the broader economy. For instance, you should look at how the inflation rates will affect your dividend earnings.

Conclusion

Investing in dividends is a lucrative idea, but only when you know what you are doing. Unfortunately, most newbies do not understand what dividends are and how they work. This article has explained to you all you would have to know before investing in dividends.