Creating a Dividend Investing Strategy

Dividend investing strategies build portfolios that generate consistent income through stock dividend payments. Such portfolios may also achieve growth through stock price appreciation. Investors looking for a steady stream of income while retaining exposure to the stock market to capture price growth should consider a dividend investing approach.

What Is Dividend Investing?

Dividends are payments a corporation makes to its shareholders from company earnings with total dividend amount set by the board of directors. That amount is then divided by the number of outstanding ordinary shares to determine the dividend per share (DPS). Dividend yield, an important metric for dividend investors, is the percent of a company’s share price that gets returned to stockholders during a year, or DPS ÷ Stock Price.

For example, a company trading at $50 with a 2% dividend yield will have a dividend payment of $1. Companies with a dividend reinvestment plan (DRIP) allow those payments to be immediately reinvested in the form of additional purchased shares rather than returned cash. Returning to the above example, instead of receiving $1 for each share owned, you would purchase an additional 0.02 share, which can realize price gains and be entitled to further dividend payments.

This makes dividend investing an attractive option for many passive investors. In fact, a Hartford Funds analysis found that since 1970, 78% of total returns from the S&P 500 index came from dividends because of reinvestment and its compounding growth, similar to the advantages of a regular savings account. While this sounds like an easy way to beat the market, investors must still perform due diligence when purchasing dividend stocks, being especially wary of two risks.

First, while high dividends are naturally attractive, investors need to make sure that these payments do not detract from a company’s growth. Because dividends come from accumulated retained earnings, it is generally assumed that each dollar returned to shareholders is a dollar not reinvested into the company via, for instance, research and development (R&D).

That could potentially limit upside growth for the stock because the company might lag competitors in innovation or face potential disruption from a startup. Developed companies rather than startups tend to offer dividends for this reason: As a company matures, it may reach a point of diminishing R&D returns or relative market conquest, meaning capital can be best deployed by returning it to shareholders. Startups, on the other hand, tend to reinvest all earnings into growing their new business.

Second, dividend investors should not simply chase high yields as that might belie company weakness. Dividend yields tend to rise as share prices fall. From the example above, if that company maintains a $1 dividend payment even as its share price falls to $35, the dividend yield rises from 2% to 2.9%. Dividend cuts might follow continued low earnings. The payout ratio, or the percent of earnings that go to dividend payments, can indicate sustainability. Companies with high payout ratios (those that spend a large portion of earnings on these payments) can be at risk for dividend cuts.

In short, dividend investing provides a great strategy for investors interested in generating income either for their own use or for share reinvestment provided that they thoroughly vet companies and do not simply chase high dividend yields.

How to Invest in Dividend-Paying Stocks

To qualify for dividend payments, investors need to hold a company’s stock on the record date. The record date is the snapshot in time when a company determines which shareholders are entitled to its next dividend payment. Missing this date, either by investing too late or selling too early, means you will have to wait until a future dividend payment to realize that income.

Importantly, you cannot simply buy a company’s shares the day before the record date and be entitled to a dividend payment. Shares bought and held through the ex-dividend date one day before the record date do not earn the upcoming dividend. Because stock prices are theoretically the present value of the sum of all future dividend payments (at least according to the dividend discount model), prices tend to fall on the ex-dividend date by the amount paid per share. A $1 dividend payment on a $50 stock would reduce its price on the ex-dividend date to $49 as the present value sum of future dividend payments decreases by that amount.

As such, if you want to qualify for a dividend payment, you should purchase stock before the ex-dividend date. This strategy does not work if you plan to immediately sell the stock. You will likely see a slight price decline on the ex-dividend date whose value you do not offset with the dividend payment because of taxation. Holding onto the stock for at least 60 days turns the ordinary dividend into a qualified dividend, which receives a more favorable tax rate. If you’re willing to forgo one dividend payment and instead want to purchase the stock at a slightly lower price, you should buy it on or after the ex-dividend date.

Dividend Investing Strategies

Investing in the best dividend stocks and creating a dividend growth investment strategy depends on your investing needs and time frame. With that said, there are a few standard dividend investing strategies for those looking to generate consistent income.

Retired investors typically want a steady stream of income while retaining market exposure to either further grow their accounts for later years or to pass down to their families. Naturally, they would not want to reinvest dividend payments. Such investors typically look for higher-yield dividend stocks with underlying company health or dividend growth stocks. The latter comprises companies with an extended record of increasing dividend payments, indicating fundamental health, they are able to return more and more cash to shareholders and increasing earnings that may boost share price. A Ned Davis Research study found that dividend growers and initiators have outperformed the broader market.

AAII Dividend Investing determines the financial strength and quality of a company by understanding its underlying financials and its ability to generate cash flow, pay its obligations and return capital to shareholders. It looks at a company’s leverage ratios, cash flows, payout ratios (earnings and cash flow) and capital returned to shareholders through dividends and share buybacks. These items are monitored to ensure that a company can continue raising its dividends.

Valuation is another key component in seeking attractive dividend-paying stocks. Stock prices tend to fluctuate between high and low extreme valuation levels, and these relationships can be used to determine a stock’s value range. Two main valuation metrics are examined: dividend yield and trailing price-earnings (P/E) ratio.

The primary valuation measure is relative dividend yield (indicated annual dividend per share divided by price per share). The dividend yield can be used to calculate a valuation estimate, indicating if a stock is expensive relative to its historical norm. Undervalued dividend-paying stocks are sought out that have current yields above their five-year historical average, yet that are expanding their dividend payments at a greater-than-average rate. Overvalued stocks are avoided—when their current yield is below their five-year average low yield.

Dividend Investing Resources

If you are interested in dividend investing and want an unbiased tool that will give you rigorous research and analysis, AAII Dividend Investing can help. Members have access to weekly commentary, monthly reports, exclusive webinars and Ask Me Anything sessions and the Dividend Investing model portfolio. This portfolio contains 24 hand-picked dividend investing stocks with attractive yields and a strong likelihood for future price appreciation. While past results do not guarantee future performance, the Dividend Investing model portfolio has nearly doubled the broader market’s dividend yield since its inception.

New subscribers also get free AAII membership with their subscription, a $49 value. Membership comes with the monthly AAII Journal, research and analysis about all facets of financial and investment planning and achieving your financial goals.

Click HERE to get started and see how AAII’s Dividend Investing can help you build your dividend investing portfolio!