What are Dividend Stocks?

What is best in life?

Conan the Barbarian had an interesting answer to this question, but times have changed since his era. It’s hard to say what is truly best in life—but we’d like to think passive income should at least make the top 10 list.

And you know what’s arguably the easiest way to generate passive income? You guessed it… dividend stocks. 💰

Unfortunately, generating a second salary through dividends isn’t easy. But with the right plan and enough time, it is possible. 

Dividend income is one of the most hands-free ways to make your money work for you, and it can also be reinvested automatically with today’s impressive technology. However, the road to this steady stream of passive income is riddled with money pitfalls—even the big-boy dividend stocks like Coca-Cola can disappoint investors.

This is why we wrote this guide—to help you understand exactly what types of dividend stocks exist, what purpose they can serve in your portfolio, how to pick the best stocks, and when to sell the rotten apples of the bunch.

So, if a passive-income-generating dividend stock is something you would like to build up—strap in, and we’ll get straight to it.

Ready? Let’s go! 🚀

How Do Dividend Stocks Work? ⚙️

Stock dividends are a share of a company’s profits distributed among shareholders in the form of a stock instead of cash. It grants shareholders additional shares along with their currently held shares, in turn diluting the value of outstanding shares. 

Typically, a company issues stock dividends if it is falling short of liquid cash reserves or wants to preserve its existing cash supply. But, dividends are not guaranteed and it’s at the discretion of the company’s board of directors. A volatile economic environment like the recession of 2008, can lead to elimination or a decrease in the dividend payout. 

For example, if an organization issues a 2% stock dividend, it instantly increases the number of stocks held by every shareholder by 2%. Therefore, if the company valuation stands at two million shares, the recent 2% stock dividend issue would add an additional 40,000 shares to the count. As a dividend stock investor, if you owned 1000 shares in the company, you would receive 40 additional shares.

Also, dividend payments can come in the form of cold, hard cash—that you have to pay income tax on, unfortunately. For example, let’s say you bought a share of Seagate Technology PLC (STX) that costs $96 and has a dividend yield of 9%. For each share you own, you would get 9% of its total value as payment each year—in this case, that is 8.64$. 

This might not seem like much money to get each year, but it can stock up—imagine you had a $500.000 or $1 million portfolio of similar dividend stocks saved up for retirement. In short, the point of dividend investing is to own enough good, diversified stocks and get a steady income via dividend payments.

DRIP and Compounding 📈

Instead of receiving the dividend stocks every quarter—DRIP it.

A dividend reinvestment program or DRIP is an understated tool to grow your nest egg as a long-term investor. DRIP reinvests the cash dividend you earn back into buying additional or fractional shares of that underlying company. 

DRIP can help you to snowball your wealth in the long run as more shares yield you more dividends. It puts time and compounding work in your favor to maximize the value of the dividend investing strategy. Besides, DRIP investing is almost always commission-free which is a big-time plus.

The key to maximizing DRIP investing potential is by knowing how to manage those investments.

Here’s a quick example of DRIP investing:

Nadia owns 2,000 shares in ABC investment trust (ABC) and has decided to participate in DRIP. ABC declares a dividend of $10/share payable on December 5, which makes her cash dividends rise up to $20,000 (2,000 shares x $10). The market price of the underlying company’s share is $100 and the DRIP offers a 15% discount for the DRIP investors.

On December 5, by reinvesting 100% of her cash dividend Nadia can buy additional shares of the company. Therefore, on the payment date, if the market share price is $100, Nadia can reap the DRIP discount advantage, and get additional shares at a price of $85 ($100 x 0.85).

Therefore, with a purchase price of $85 and $20,000 in cash dividends, Nadia will now own an additional 235.294 shares ($20,000 / $85) in the ABC investment trust. However, the fractional amount (0.2941) is carried to the next dividend payment and Nadia will own an additional 235 shares.

Types of Dividend Stocks 🗂

History has showcased the long-term, buy-and-hold approach that helps to secure wealth from dividend stocks. Therefore, when you start evaluating dividend stocks, target a handful of specific dividend categories/sectors. To narrow it down, further evaluate stocks based on their growth, valuation, and solvency ratios.

However, this practice would come in handy if you know a little about the types of dividend stocks.

Qualified vs. Ordinary Dividends 👇

The main difference between qualified and ordinary dividends is that the former gives its owners certain tax benefits and priority over other investors. However, qualified dividends have a number of criteria that need to be met.

A qualified dividend needs to be paid either by a U.S. company, a business from a country that has a tax treaty with the U.S, or a foreign company that trades in the U.S. Also, qualified dividends reward long-term shareholders—to qualify, you must hold the shares for more than 60 days during a 121-day period to get a qualified rate. 

Not every dividend stock makes the qualified dividend cut. For instance, unorthodox stocks like real estate investment trusts (REITs) and master limited partnerships (MLPs) do not pay qualified dividends as they have complicated tax rules. Besides, certain market funds and other “bond-like” instruments generally pay ordinary dividends. 

Besides, if you are aware of the dividend type—ordinary or qualified, it can help you to plan your dividend investment strategy properly. You can arrange for the lower-taxed qualified dividends to be paid into your taxable brokerage account while the higher-taxed ordinary dividends can be paid into your IRA, which will ease your obligation to the money-hungry Uncle Sam.

Preferred and Special Dividends ✅

While dividends are guaranteed, some shares enjoy more benefits. Shareholders who hold preferred stock have a higher claim on a company’s assets than the common shareholders. But, the claim is lower when compared to the bondholders.

If a company decides to cut its dividends under any circumstance, it starts right from the bottom. The bondholders would be paid first, followed by the preferred shareholders, and then if there’s anything left, it goes to common stockholders. Similarly, companies use the same hierarchy to distribute capital in good times. The preferred shareholders enjoy a larger dividend payment than any common shareholder.

Another category of dividends is special dividends that are mostly bonuses on top of your dividend paycheck. Usually, these one-time extra dividends tend to be in cash and are a much larger amount than regular dividend payments. A company might decide to allocate such dividends on a particularly good quarter or if it is looking to change its entire financial structure.

Dividend Funds 🏛

Dividend funds like mutual funds and ETFs, are an easier alternative to building a diversified dividend portfolio. Typically, mutual funds are actively managed by a professional who selects the stocks to invest in—therefore, these funds come at the cost of a higher expense ratio. Unlike mutual funds though, dividend ETFs are inexpensive as they don’t have an active investment manager hand-picking stocks.

Generally speaking, ETFs are mostly inclined towards slow-growing sectors such as banking, utilities, consumer staples among many. Besides, an ETF also requires the companies it wants to invest in to have a long history of dividend payments. This implies that the ETF’s would eventually miss out on the new but stable dividend stock like Apple, which only started paying their dividends in 2012.

Therefore, with so many uncertainties, and rules, it’s essential that investors diversify across sectors to be able to reap profits. 

Why Buy Dividend Stocks? 💡

Dividend stocks have been often understated—they can have a snowball effect on your returns and can be a stable source of passive income. Typically, investors prefer to invest in companies that raise their dividend payouts year after year to outpace inflation.

Once an organization decides to start or raise its dividend payments, investors expect it to be maintained, even during volatile economic times. As dividend payouts are directly proportional to a company’s financial well-being, a slight indication of instability can steer away investors. 

As companies pay their dividends at different times, investors who have retired from professional life can organize their payment schedule to sustain better. Retirees can also organize their payments in IRA accounts to let their money grow tax-free. Meanwhile, younger investors can put those dividends to work by automating them with DRIPs. 

Dividend stocks also often benefit inventors because they have higher yields than bonds when interest rates are low, while simultaneously offering the potential for share price appreciation. Even if the price falls, the dividend can cushion a portfolio with a steady income, and if you reinvest those dividends, a lower share price gets you more shares per dividend.

However, investors should also be wary of the overwhelming change in the market all the time to keep losses at bay. While high-yielding dividend stocks look like shiny golden eggs, they are not always what they appear to be. Therefore, it’s advised to be continuously researching and making market calculations to evade any kind of loss. 

How to Buy Dividend Stocks 👨‍🏫

Buying dividend stock needs research and mindfulness to build a successful investment portfolio. Here are 5 steps to get you started when buying dividend stocks:

1. Research Quality Stocks 👩‍💻

As a dividend stock investor, you need to think big. Big corporations have more financial stability and lower volatility. They are more likely to remain steady when the markets are turbulent and pay out dividends on time. 

Therefore, start by putting together a list of big companies that pay high dividends. However, don’t forget to keep a check on their financial history and their position in the industry to make a fair decision. 

2. Read the Stock’s Quote 🏷

You can learn more about the payout ratio by looking at a stock’s quote. The stock quotes are meant to summarize all the information you need to be able to invest. If your stock quotes are bereft of any information on dividends, then it means the stocks aren’t offering any yields.

3. Purchase the Stock 💰

Once you’ve finalized the stock, purchase it. You can either do it either through a good stock broker or directly through companies. However, when you purchase stock directly through a company, you have to make a minimum investment between $25 to $500—using a broker is an incomparably easier and more flexible option.

However, you can also purchase dividend stock through a stock broker. There are a number of brokerage firms with their own set of rules to facilitate purchases for you. After all, choosing your first broker is an important decision as the platform would determine what and how to trade. Familiarizing with the process of how to choose a broker, can help you make better decisions. 

4. Add DRIP 🤖

Companies give away dividends either as a direct cash payment or through dividend reinvestment programs as they automatically put a fraction of an investor’s portfolio on autopilot. This wealth-building program essentially reinvests all your dividends payments and gets you additional shares.

5. Track Your Assets 📝

Companies can either choose to pay a handsome dividend, eliminate, raise, or lower dividends at any point in time. Therefore, it’s crucial to track your dividends and keep a clear eye on the investments.

What to Look For in Dividend Stocks 🕵️‍♂️

Before you invest, it is crucial to be able to diversify your assets. Naturally, you don’t want your money in a single company because you’re toast if it fails—diversifying your portfolio by buying a bunch of different stocks is a much safer option.

However, not everyone is a pro-investor. That’s why it’s crucial to understand how the stock market works to some extent. After all, basic knowledge can help you judge dividend stocks with confidence—but doing that isn’t easy for beginners. Before you dip your toes in investment, get yourself acquainted with the basics of how the stock market works.

Once you are familiarized with the basics of dividend stocks, here are a few key criteria to look for in dividend stocks, before you add them to your portfolio.

1. History of Raises 🕰

It’s always a smart idea to look at the history of dividend raises. Ideally, it’s a good sign when an organization raises its dividend year after year, especially during dire economic times.

2. Steady Revenue and Earning Growth 📈

The best dividend stocks are from companies that have a stronghold on the ever-growing market with a unique service or product. It ensures a stable income flow instead and avoids all-over-the-board earnings.

3. Payout Ratio ➕ ➗

A stock’s payout ratio reveals the percentage of earnings a stock pays to its shareholders. A low payout ratio (i.e., 60% or less) is an excellent sign of a sustainable dividend stock. 

4. Competitive Advantages 🚀

This is one of the most important criteria to look for when buying dividend stocks. A durable competitive advantage on a dividend stock can come from companies who sell proprietary technology, high customer switching costs, a brand name, are among the few forms. 

5. High Yield 🔝

No one prefers to keep money on the table. This is essentially what low-yield stocks do, however. While there are other advantages that we’ll dig into a little later, it’s important to be aware of this.

When to Sell Dividend Stocks 📅

Investors aim for long-term profits with dividend stocks. Therefore, instead of blind investing, it demands the investors to focus on holding onto sustainable stocks to profit. However, the long-term is not forever, but it means you would want to review it regularly to ensure your investment decisions are holding up. 

Then, when should you sell a dividend stock? While some hold onto their stocks with the hope of making more profits later, some investors are too scared to give it away. Therefore, it’s crucial to look for warnings that tell you when to do the right thing.

Factors to Consider When Selling Dividend Stocks 👇

Even the shining examples of dividend stocks aren’t perfect. Sometimes you need to purge your portfolio of bad investments to really see that dividend money roll in. Here are some of the factors to keep in mind when considering whether to sell a stock or not.

Dividend Cut ✂️

If a company reduces the dividend, it might be the right time to call it a day on that stock. However, dividend cuts are not the final warning sign to immediately sell your stocks—check if this dividend cut is followed by a bad financial report and consider selling the stock if the company is running out of money to pay shareholders. You can start by the method of fundamental analysis to evaluate a company and then move forward.

Dividend Yield Too High ⚠️

A good rule of thumb is to look at the dividend yield—is it high or low? If it’s too high, there’s a high probability of an imminent dividend cut. However, If the yield still looks a bit lofty, and you have a hunch, then it’s better to dig deep into their dividend history and pull up the balance sheet.

Sharp Stock Decline 📉

Well, if the stock prices have a sharp decline and it’s not smooth sailing, it’s better to be prudent to sell your stocks and not look back. However, if we’re talking about an all-around market crash, it’s not a good idea to sell—everything is cheap during a crash, and your stock might be doing just fine comparatively. 

Also, a faltering stock price might not change dividend yields if the company in question is actually doing OK financially. For example, Lloyds Bank continued normal dividend payments even after declining more than 70% in 2020.

CEO Departure 🏃‍♀️ 💨

If the company CEO departs mid-way without a long-term business strategy in place, it’s a major warning. Then, it only means the company is not in good shape and it is only going to struggle. 

Change in Industry 🔀

Most investors bet on successful blue-chip dividend growth stacks to yield profits. But, nothing stays the same, and factors like volatile economic conditions, advanced technology, etc. can make or break profits for you. Paying attention to the rapid industry changes that affect your investments. 

These signals are a mixed bag of hard sell and circumstantial rules that investors should consider when selling a dividend stock.

Small Stock Dividend vs. Large Stock Dividend ⚖️

When a company issues a stock dividend to its investors, the equity value remains the same. The stock dividend represents distribution to the shareholders—in reality, they do not represent any transfer of value to shareholders. 

Therefore, this requires a journal entry for the company issuing the dividend as companies use stock dividends to convert their retained earnings (net income left after the business has paid out dividends) to contributed capital. The amount transferred between these two accounts depends on whether it is a large stock or a small stock dividend. 

A stock dividend issued to a shareholder is considered small if it is less than 20-25% of the outstanding shares of common stock. The small stock dividend journal entry is treated as a regular cash dividend. On the other hand, large stock dividends are ones that payout more than 20-25% of the existing common stock. 

While a small stock dividend is recorded at market value, a large stock dividend is similar to a stock split. It is assumed that the market will recognize the large stock dividend and adjust accordingly as the business is now represented by an increased number of shares. 

Therefore, investors can check the records to understand the sustainability of the stock before investing.

Downsides of Dividend Stocks 🚨

While dividend stocks definitely stand out as a great tool to accumulate wealth, it does have its share of downsides. Let’s take a quick peek:

1. Clientele Effect 📉

General Electric (GE) was a blue-chip stock with a great rate of growth and a steady dividend back in the day. So much so, that if you had bought $100 of its stock in 1970 and sold it in 2016, the average return would be around 21% per year. This would put your final net worth with DRIP at $784,703.30—very nice indeed. 

However, the great recession forced GE to sell its lucrative services and exposed debts. It was followed by frequent leadership change and the global pandemic was the final nail in the coffin. These downfalls have slashed GE’s stock worth. 

Therefore, even blue-chip stocks might lose their shine and can get risky. Changes in companies’ dividend policy changes can have adverse effects as investors’ accumulated share appreciation is affected as most investors might sell and move on. This is known as the clientele effect.

2. Dividend Stocks are in Narrow Buckets ✔️

Most of the reliable dividend stocks fall in the sectors like banks, energy, utilities, financial services, and consumer goods. While investing in such stocks can produce income, it indicates that there’s a cap to the number of company stocks you can invest in.

Besides, the narrow bucket caveat can be a threat when a pandemic or a disastrous economic year comes looming in. For instance, the oil industry crashed in 2020 which led even reliable dividend stocks like Exxon-Mobile to experience its first-ever loss as a public company. They had to cut jobs in 2020, and also are a record debt of $70 billion. A year later, Exxon released its plans to boost earnings, grow its dividend, slash debt, and fund projects.

3. High Dividend Payout Risks ⚖️

A lot of factors are responsible for the fates of companies. Beginners might find it difficult to strategize and research to pick the long-running stocks. Moreover, if a company offers a high dividend payout ratio that isn’t sustainable, investors might find themselves in soup. Therefore, investing in dividend stocks is subject to market risk. 

4. Difficult to Figure out the Right Mix 🔎

Figuring out the right mix of asset allocation can get to the nerves of beginner investors. A balanced mix of dividend stock investments depends on your risk tolerances—therefore, using the bucket strategy to figure out the right amount of income you need is a less nerve-racking way. 

Dilution Effect Explained 📖

The dilution effect is more like watering down your lemonade. While the recipe calls for one part lemon juice to four parts water, you added six parts water—diluting the lemonade. Similarly, when an organization issues shares to its shareholders, the value of each share is diluted.

Let’s clear the air with an example.

If a corporation has a market cap of $750 million, and there are over 200 million shares outstanding, the stock price is $3.75 ($750/240). If the board decides to declare the stock dividend of 0.1%, the number of shares outstanding will add an additional 40 million shares.

As the shares increase, the company’s market cap still remains the same but the share price drops to $3.13 ($750/240). This is called the dilution effect where the share prices drop, but the ownership stays intact. 

In 2020, the pandemic impacted AMC business that witnessed a plummeting revenue. AMC quickly added survival capital to its balance sheet through a series of debt and stock offerings. S&P Global Market intelligence reports that the company tripled its shares outstanding to 374,097,577 shares from 103,849,861 shares reported at the end of 2019. 

Although the dilution provided AMC with some cash to stay afloat, its share price reached a low point in early January 2021. AMC’s share was trading under $2 a share while on Dec. 31, 2019, it was closed at $7.24 per share. The share price was diluted by a whopping 72% as the number of shares tripled.

The Bottom Line 🏁

Well, if you have come this far, you are now aware of the basics of the dividend stocks – the what, why’s and the how’s. Although it can get challenging for a beginner to make decisions on dividend stocks investment, reading up more and keeping a close eye on the stock market can get you results.

Now, instead of pondering over, it’s time for the investor in you to rise to the occasion and get ready to identify and start investing. Whichever stocks or yields you choose, always remember your investment goal, be mindful of your risk tolerance, and always keep your investment portfolio close to your heart, to succeed and make the best decisions. 

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