Is Dividend Investing a Good Strategy?

Many investors like to share stories of how they got into some hot momentum stock early or the frustration of how they could have but didn't. Yet far fewer share tales of increasing their portfolio slowly but surely through the humbler means of compounding dividends over time.

Dividend stocks lack the wow factor of buying early in Google (later Alphabet Inc., GOOG) or NVIDIA (NVDA), but reinvesting these payouts has been among the most reliable ways to produce long-term gains. While you might not impress friends at the next BBQ or dinner party with how you reinvest your neat little dividends each year, investing with dividend returns can deliver the most potent portfolio income over time.

Below, we take you through what dividends are, how to measure the companies that provide the most stable payouts, and the pros and cons of using a dividend-centric strategy.

Dividend Basics

Dividends are your slice of a company's profits. When a company makes money, its board of directors can share some of those earnings with stockholders through regular cash payments called dividends. Not every company pays dividends—some prefer to reinvest all profits into growing the business; these companies' shares may be among those known as "growth stocks."

To receive a dividend, you must be a "shareholder of record" by a specific date set by the company. Buying a stock before the "ex-dividend" date means you'll get the next dividend. It's essentially a sign-up deadline—otherwise, you'll have to wait for the next dividend period.

For U.S. companies, dividends come from after-tax profits. When you receive them, the Internal Revenue Service (IRS) considers them ordinary income on which you'll pay taxes. However, some dividends qualify for lower tax rates if you meet specific holding period requirements.

Now that you have a basic definition of a dividend and its distribution, let's get into more detail about what you need to understand before making an investment decision.

Types of Dividend Payments

Dividends come in various forms. When people talk about dividends, it's usually about regular cash payments companies make to common shareholders from their profits. However, alternative payment methods and types of dividends can be paid.

 Here is a list of the various labels for dividends:

• Cash: A cash dividend is a cash payment from a company to its shareholders. This is the most common type of dividend.
• Common: If a dividend is called "common", it means it's paid to owners of the company's common stock.
• Liquidating: These are dividends paid by companies winding down their operations. If money is left after paying off debts and liabilities, it can be shared with shareholders as a liquidating dividend.
  
• Preferred: Preferred dividends are reserved for owners of the company’s preferred stock.
• Property: Companies may, in rare cases, distribute other assets to shareholders, such as real estate inventory, or intangible assets, such as patents.
• Scrip: A scrip dividend gives shareholders the option to receive additional shares in the company, often at a discount, or a cash payment later. It comes as a certificate; the shares are usually newly created, not preexisting ones.
• Special: A special dividend is a one-off dividend companies pay shareholders on top of the regular dividend. This extra dividend is usually the result of an influx of cash from something like an asset sale or a particularly good period of trading.
• Stock: With a stock dividend, a company distributes additional shares to shareholders instead of cash.

How To Pick Dividend-Paying Stocks

Want to know if a dividend-paying stock is worth your money? Dividends are derived from a company's profits, so it's fair to assume that, in most cases, dividends are generally a sign of financial health.

For most investors, dividend stocks add stability to their portfolio—like shock absorbers for your car. Here's why: Let's say you invest $10,000 in a stock paying $400 annually in dividends. Even if the stock price drops 4% over the year, your dividends help offset that loss, protecting your total investment.

Assuming a 10% dividend yield, your $10,000 investment in ABC Corporation would be worth $11,000 after one year even if the stock price is unchanged. On the other hand, if ABC Corporation is trading at $90 per share a year after you bought it for $100 a share, you would still break even on your total investment after receiving dividends ($9,000 stock value + $1,000 in dividends).

This is the appeal of buying stocks with dividends: they help offset declines in the stock prices and boost the overall return on your stock holdings. This is why many investing legends such as John Bogle and Benjamin Graham advocated buying stocks that pay dividends as crucial for calculating an asset's total "investment" return.

Let's review some figures you'll want to consider when looking at dividend stocks. No calculator needed: These are typically provided for individual stocks on most financial platforms.

Dividend Yield

The dividend yield is the amount paid out per share divided by the price per share. A counterintuitive quirk of the dividend yield is that, all else being equal, it decreases as the stock price increases.

Dividends are generally paid on a per-share basis. Here's another way of looking at it: If you invest $10,000 in ABC Corporation at $100 per share, you'd own 100 shares. If ABC pays $10 per share annually in dividends, you'd receive $1,000 in dividend payments, giving you a 10% yield ($1,000/$10,000).

As such, the dividend yield formula is as follows: Dividend Yield = Dividend/Price × 100

Thus, the dividend yield can also be calculated as the total dividend amount ($1,000) divided by the cost of the stock ($10,000), which is 10%.

If you bought ABC Corporation at $200 per share instead, the yield would drop to 5% since 100 shares now cost $20,000 (or your original $10,000 only gets you 50 shares instead of 100). This is why the dividend yield drops if the stock price moves higher, and vice versa, assuming the dividend itself doesn't change.

Dividend yields often come down to growth expectations. Stocks predicted to deliver faster earnings and dividend growth tend to have lower dividend yields. This is because investors bid up prices on shares with this potential, diminishing the current yields. Meanwhile, stocks with a slower growth outlook typically languish with higher yields to compensate for the limited upside for the price.

Still, projected dividend growth alone doesn't dictate yields. Companies whose stock is lightly traded (it has low volume) typically have higher yields to lure in potential buyers. Stability is also important: Firms that reliably provide dividends year after year may not necessarily see perpetually rising yields if share prices go up.

The average dividend yield on S&P 500 companies that pay a dividend fluctuates somewhere between 1% and 3%, depending on market conditions.

Dividend Yield vs. Growth Potential

Fast-growing companies often have lower yields because investors are willing to pay more for their shares, focusing on future potential, and perhaps rising share price, rather than present dividends. It's like paying a premium for a promising startup versus an established but slow-growing business.

But growth isn't the whole story. Some stocks offer high yields simply because they're less popular with investors. Think of it like a store offering bigger discounts to attract customers during slow periods. However, companies with long track records of steady dividend payments, like many consumer staples firms, might see their yields decrease over time as investors bid up their share prices, viewing them as reliable income sources.

For example, a technology company growing at 20% annually might yield only 1%, while a mature utility company growing at 3% annually might yield 4%. The market prices the tech company's shares higher because of its growth potential, which pushes its yield down. Let's look at a simplified example:

Dividend Payout Ratio

This ratio gives the dividend as a percentage of earnings. The dividend payout ratio is calculated by dividing the dividend amount by net income for the same period.

To calculate it, divide the total dividends by net income. For example, if a company makes $100 million and pays out $60 million in dividends, its payout ratio is 60%.

So, what ratio is good? There’s no ideal percentage for all companies. The dividend payout ratio tells you how much of a company's profit goes to shareholders versus being reinvested in the business. Think of it like your paycheck—if you're spending 90% of your income on bills, you might be cutting it too close. Companies face similar decisions.

While there's no magic number, extremely high ratios can be risky—like someone barely making it from paycheck to paycheck. Generally speaking, high payout ratios are considered risky. If earnings fall, the dividend is more likely to get cut, resulting in the share price falling.

Lower ratios, meanwhile, could suggest the potential for the dividends to increase in the future, or they could mean that the stock has low yields. Very low ratios might mean room for dividend growth but could signal a stingy company. In addition, some companies have higher expenses than others, which affects their ratio.

Dividend Coverage Ratio

The dividend coverage ratio is calculated by dividing a company's annual earnings-per-share (EPS) by its annual dividend-per-share. The dividend coverage ratio indicates the number of times a company could pay dividends to its common shareholders using its net income over a specific fiscal period. Generally, a higher dividend coverage ratio is more favorable.

As with the other ratios, a decent value depends on the company, its expenses, and its sector. Obviously, the higher the dividend cover, the safer the dividend should be. Investors generally like to see a dividend coverage ratio of at least two.

Dividend Growth Rate

The dividend growth rate tells us how much a company’s dividend has grown annually over a period of time. Higher rates may catch investors' attention but aren’t necessarily a good thing. They could indicate that a company started from a low base or is making unsustainable, rapid increases.

When it comes to dividend investing, reliability trumps big, unsustainable-looking payments. Companies with a steady track record of gradually increasing their dividend above inflation are what income investors yearn for.

Free Cash Flow

Free cash flow is the money left for a company after paying all its bills and investing in its future via capital expenditures. Unlike simple earnings, this metric shows how much cash a company actually has available to pay dividends. It's like checking your bank balance versus just looking at your paycheck—it gives you the real picture of what you can afford to spend.

For dividend investors, strong free cash flow is crucial. If a company's dividend payments are higher than its free cash flow, it might be borrowing money or selling assets to pay dividends—a situation that isn't sustainable.

Net-Debt-to-EBITDA Ratio

The net debt-to-EBITDA ratio lets you check on how manageable a company's debt is given its income. A low ratio suggests a company can pay off its debt relatively quickly with its earnings, while a high ratio might mean it's struggling.

For dividend investors, the net-debt-to-EBITDA ratio serves as an early warning system. If a company is already stretching to pay its debts (shown by a high or rising ratio), it might have to choose between paying dividends and paying creditors—and that's a battle creditors usually win.

Risks of Investing in Dividend Stocks

During the financial meltdown in 2008-2009, almost all major banks either slashed or eliminated their dividend payouts. These companies were known for consistently stable dividend payouts each quarter for decades—until suddenly, they weren't. In other words, dividends are not guaranteed and are subject to macroeconomic and company-specific risks.

Another downside to dividend-paying stocks is that companies that pay dividends are not usually leaders in growth. There are some exceptions, but high-growth companies typically do not pay sizable amounts of dividends to their shareholders even if they have significantly outperformed the vast majority of stocks over time.

Growth companies spend more on research and development, capital expansion, retaining talented employees, and mergers and acquisitions. All earnings are retained for these companies and reinvested back into the company instead of being used to issue a dividend to shareholders.

It's also important to be aware of companies with extraordinarily high yields. If a company's stock price declines, its yield goes up. Many rookie investors get pulled into buying a stock based on a potentially juicy dividend.

Advantages and Disadvantages of Dividend Investing

Investing in stocks that pay a dividend has pros and cons. Yes, there are a lot of advantages. However, there’s also a price to pay for those benefits.

The most obvious advantage of dividend investing is that it gives investors extra income to use as they wish. This income can be reinvested or withdrawn and used immediately.

Dividends can also be a sign of quality. Companies that have paid dividends for a long time are generally stocks that help investors sleep easier at night. They generate a lot of cash and have predictable earnings that don’t fluctuate much.

Volatility is something else to watch. The share prices of top income-generating stocks generally don’t plummet. But they don’t rise much, either. 

There is the opportunity cost. By investing in dividend-paying stocks, you’re not investing elsewhere. Putting your money into dividend stocks means prioritizing stable returns over those with more upside growth and share-price potential. Stocks with high growth potential tend to invest all their earnings back into the business. Those companies have the biggest chance of rising in value.

Other drawbacks of dividend investing include some potential extra tax burdens, especially for investors who live off the income. There's also the risk it gets cut or stops growing. Once a company starts paying a dividend, investors become accustomed to it and expect it to grow. If that doesn’t happen or it's cut, the share price will likely tumble.

Dividend Cut Example

Cutting dividends is generally a last resort for companies because it tends to irritate investors and weigh on share prices. However, companies cut their dividends quite often. Even big companies renowned for being reliable dividend payers can go through rough patches and be forced to reduce how much income they pay investors.

One example is 3M Company (MMM). In May 2024, the maker of Post-it notes, industrial adhesives, and roofing granules lost its status as a dividend aristocrat, a small group of companies that have consistently increased dividends for at least 25 years, after more than halving its quarterly dividend from $1.51 per share to $0.70.

3M's struggles were well documented. A series of legal and regulatory challenges have been a significant drain on cash flow. The industrial giant first responded by spinning off part of its healthcare division into a separate business. It then freed up more cash by cutting its dividend.

Initially, 3M's stock price dropped by about a quarter. However, not all investors were unhappy with the move. They viewed the dividend cut as necessary to bolster the company's finances and free up cash to get the business growing again and noted that the yield remains in line with peers. Income investors will be less forgiving.

By cutting its dividend, 3M damaged its long-standing reputation as a reliable dividend stock, which may lead income investors not to trust the company and invest elsewhere.

Nevertheless, by the end of the year, 3M's stock price was up significantly—more than 60%. That's after reporting good results in the second and third quarters of 2024, plus mostly cheery analyst reports.

Dividend Aristocrats

Investors don't just look at various metrics when choosing which dividend-paying stocks to invest in. They also pay a lot of attention to stability of dividend payments. Some companies have a habit of being overgenerous and then being forced to backtrack and slash their dividends when they run into challenges. Others have developed a reputation for being much more reliable.

Companies that don't cut their dividends are celebrated. Members of the S&P 500 that have increased their dividends for at least 25 consecutive years are known as dividend aristocrats. Dividend aristocrats have the following tendencies:

• They outperform during market downturns.
• They have strong balance sheets.
• They generate consistent cash flow.
• They operate in stable industries.

In the table below, those with the longest tenure are listed first.

The Bottom Line

Dividend-paying stocks offer several benefits to investors. First, they provide a regular income stream, which can be especially attractive to income-focused investors such as retirees. Second, dividends are often seen as a sign of a company's financial health and stability, as they indicate that it's generating enough profits to distribute at least some to shareholders. Reinvesting your dividends can lead to compounding returns over time, enhancing long-term investment growth.

Lastly, dividend-paying stocks can offer some protection in volatile or declining markets, as the dividend yield can provide a cushion against falling stock prices. Whether and how much to focus on dividend-paying stocks depends on your investment horizon, tolerance for risk, your finances, and long-term goals.