It is increasingly difficult to generate investment income in this low interest rate environment. The interest rate on long term United States Treasury Bonds like the 10 year Treasury bond are yielding just 1.579%. That is worse than the 2% yield on a high interest money market account. The interest rate on 5 year certificates of deposit are yielding between 2.50 to 2.70% annually. These rates are not appealing enough for income investors to commit to tying up their long-term capital for a 5 to 10 year time period. Investors seeking to generate investment income need to look elsewhere. Fortunately, dividend stocks provide a great income stream for your investment portfolio during these low interest rate times.
The Difference Between Interest and Dividends
Investment income is typically generated in the forms of either interest or dividends. While the two may appear similar, they come from vastly different sources.
Interest is the return you earn on money lent to a company. Interest is money that is promised to you as a creditor of a company and contractually must be paid out to you. You earn interest on bonds, certificates of deposit, and savings accounts.
Dividends are a distribution of the profits paid out by a company to shareholders of its stock. Dividends are paid to common stock and preferred stock shareholders. Stocks, mutual funds, and exchange traded funds distribute dividends to shareholders. Since dividends are distributed from profits, dividends are not required to be paid out by a company. Investors have no legal claim to receive dividends.
If you want to become a millionaire by investing then you need to add some dividend income to your investment portfolio. Dividends are the passive income investor’s dream as investor’s reap the benefit of companies returning cash back to investors. Evaluating the yields is a useful method for identifying overvalued and undervalued stocks as well. A higher yield can help investors locate potential value stocks.
Advantages of Dividends
Dividends are great because they allow investors to receive a tangible return on invested capital without having to redeem shares. Cash dividends provide a regular income stream for income seeking investors.
Lower Tax Rates
Qualified dividends are not taxed as ordinary income but are instead taxed at the long-term capital gains tax rate. Qualified dividends tax rates are either 0%, 15%, or 20% based on the taxable income of the shareholder.
Dividend stocks investors earn higher total returns than non-dividend stock investors because their returns include dividend returns plus price appreciation. Dividends can easily add 3-4% annually to your investment returns.
Frequently Asked Questions About Dividends
Where should you look for dividends?
The best companies to receive huge dividend payouts from are cash cows. Cash cows are large mature companies with slow growth rates that generate large amounts of free cash flow. Companies with high growth rates do not pay large dividends because free cash is reinvested back in the business to fuel long-term growth.
Non Dividend Stocks
Amazon (AMZN), Netflix (NFLX), and Square (SQ)are examples of high growth companies who invest in growth but not in returning capital back to shareholders.
United Parcel Service (UPS), GlaxoSmithKline (GSK), and AbbVie (ABBV)are examples of companies that pay quality dividends with their 3.40%, 4.70%, and 6.8% yields respectively.
Exchange Traded Funds
Vanguard High Dividend Yield Index Fund ETF (VYM), Spyder S&P 500 High Dividend ETF (SPYD), and iShares International Select Dividend ETF (IDV) provide yields of 3.10%, 6.47%, and 5.4% in different market sectors.
The financial, energy, and consumer staple sectors often have stocks that pay the highest dividends.
Good dividend stocks have strong amounts of free cash flow, solid earnings, and low dividend payout ratios. Payouts of dividends should be less than 50% of earnings or free cash flow. The lower the dividend payout ratio, the more sustainable the dividend. Avoid companies with massive amounts of maturing debt as bondholders and creditors have preference to cash payouts over investors.
How are dividends paid?
Dividends payouts come in two forms:
Cash dividends are the most common type of dividends received. Investors have the option of receiving these payments in cash or can automatically reinvest the cash dividends to purchase additional shares of stock. Shares can be reinvested through a Dividend Reinvestment Plan also known as a DRIP.
Stock dividends are payments in the form of additional shares. These dividends are less common than cash dividends and are often made by companies who wish to reward shareholders without distributing cash.
I always prefer to receive cash dividends because they offer greater flexibility with the option to reinvest in shares as well.
How often will investors receive a dividend?
Dividends are typically paid out on a quarterly basis which means investors in stocks, mutual funds, and exchange traded funds may receive a distribution every 90 days. Some investments pay dividends only semiannually or annually.
What is a good dividend yield on an investment?
The minimum yield to classify as a dividend stock is 3% as that is a return that keeps pace with inflation. The sweet spot for dividends is a yield between 3 and 6%. Be skeptical of double digit yields as companies with yields of 10% and up are fools gold. Incredibly high yields are often unsustainable and are an early warning sign of a coming dividend cut.
What are the important dividend dates?
The two dates to note are the record date and the ex-dividend date.
Record date – the day that you must be listed on the company’s books as a shareholder to receive a dividend.
Ex-dividend date- this is one day before the record date. You must purchase a stock before its ex-dividend date to receive the next dividend payment.
Who should purchase dividend stocks?
The answer is a all investors. Retirees, income seeking investors, young investors should all include dividend stocks and funds to their portfolio. Older investors should use the dividend income to pay for bills and living expenses. Younger investors should reinvest cash dividends to accumulate more shares of stocks. Dividends stocks are especially useful for generating positive returns in volatile markets.
Now you see why dividends are a vital part of your investing strategy. Be sure to add some stocks, mutual funds, or exchange traded funds that pay dividends to boost your returns.