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Dividend Investing

Curious about dividend investing? Read on.

Following growth rates is an important aspect of dividend investing. [©Shutterstock, 2010]
©Shutterstock, 2010
Following growth rates is an important aspect of dividend investing.

Dividend investing is a type of stock investing wherein companies offer their shareholders small portions of their earnings, known as dividends, as a reward for investing in the company's stock. The dividends are often quoted as either a percentage of a company's stock's market price or as a specific dollar amount the company pays for each share held by its investors, known as dividends per share. According to Investopedia, dividends do not typically offer investors the same potential for rapid growth as small-cap and other volatile stocks, but they do offer a more reliable way to receive solid, long-term returns on investments.

Standard and One-Time Dividends

Not all companies reward their investors with dividends; some companies rely on the increase in the market price of their stock to earn profit for their investors. Companies that do offer dividends often divide them into two major types: the common standard dividends, and one-time dividends, which are rare.

Investing in standard dividends is a straightforward and predictable process -- for each share owned, investors either receive a specific amount of money, or a number of additional shares over the course of the investment period, typically one year. Since many companies report earnings quarterly, dividends often are distributed to investors four times a year instead of annually. Although a healthy company should be able to pay dividends to all of its shareholders, if a company is forced to liquidate its assets after declaring bankruptcy, for example, shareholders of preferred stock are paid before common stock. Therefore, preferred stock is less risky than common stock, but usually does not perform as well and shareholders do not have voting rights.

Occasionally, companies issue one-time dividends after experiencing a substantial increase in their earnings or net worth. Events that commonly allow companies to pay these special dividends include litigation wins and investment liquidation or sales. Unlike standard dividends, which are most frequently paid in cash, one-time dividends may be paid in cash, property or stock.

Dividend Payout Schedule

There are four important dates investors should remember when investing money in dividend stocks: the declaration date, date of record, ex-dividend date and payment date. The declaration date is the day the company officially announces it will pay a dividend to its shareholders. In order for this announcement to be made, the company's board of directors must agree to the terms of the payment, such as the amount of the dividend payment and the date on which it will be paid.

According to the Securities and Exchange Commission, the date of record, also known as the record date, is the date when a company makes a record of shareholders who will receive the dividend declared on the declaration date. After deciding the date of record, either the National Association of Securities Dealers or the participating stock exchanges fix the ex-dividend date. Only shareholders who purchase stock before the ex-dividend date will receive the forthcoming dividend; investors who purchase on or after this date lose the dividend to the seller. About a week after the date of record, the company then mails the dividends to its shareholders on what is known as the payment date.

Basic Dividend Investing Strategy

Investors interested in fast growth and big returns usually shy away from dividend stocks, which tend to perform better over long periods of time. Instead, investors willing to assume more risk for greater returns may invest in startups and small-cap companies with less than $2 billion worth of stock on the market. These companies usually do not offer dividends so that earnings can be reinvested into the business. The stock prices tend to be more volatile, but investors have the opportunity to earn significant returns over the shorter term if the market price of shares shoots up.

Investors interested in receiving steady, reliable returns from carefully selected stocks should consider dividend investing. When evaluating whether to buy a dividend stock, investors should first consider its dividend yield, or what percentage of the share's market price shareholders have historically received. Prospective investors should not expect these percentages to be dazzling -- most of the yields on Dividend.com's list of the best dividend stocks fall between 4 to 7 percent. However, when coupled with a company's steady financial growth and increased market prices, dividend stocks can post respectable long-term returns. Large companies like General Electric, Johnson & Johnson, Coca-Cola and McDonald's are some of dividend investors' favorites because they post good earnings and tend to perform well over time.

Other Tools for Dividend Investing

Shareholders periodically should evaluate whether companies appear to be able to pay dividends without risking financial stability. Calculating the dividend coverage ratio by dividing a company's earnings per share by its dividends per share gives investors a good idea of whether it has earned enough money to cover its obligations to shareholders. An investor should look at the dividends per share over the last year, not necessarily only the last dividend paid. In general, a ratio of 2 or 3 is a good sign the company is doing well enough to pay dividends without losing control of its assets. For example, consider these two hypothetical companies:

  • Company XYZ earns $6 per share and pays a $3 dividend per share to each of its stockholders, which calculates to a reasonable dividend coverage ratio of 2.
  • Company ABC earns a similar amount per share ($5.8) but offers a $5 dividend per share to its stockholders for a low dividend coverage ratio of 1.16.

In the case of Company ABC, a large dividend payout may seem enticing, but it suggests that the company is at best poorly managing its finances, and at worst headed for financial collapse and liquidation. Likewise, investors should be wary of extremely high coverage ratios (i.e., above 5), which suggest the company is unfairly keeping its earnings from them.

Investors can find a company's earnings per share, dividends per share and other important financial statistics using the SEC's EDGAR Database.

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