There are several good reasons to invest in dividend stocks . These stocks can produce reliable streams of income, and have the potential for excellent long-term compound returns, just to name a couple. However, not all dividend stocks are the same, and not all dividend stocks are appropriate for beginners.
With that in mind, here's a rundown of what beginners should know before buying their first dividend stocks, as well as three real-world examples of dividend stocks that could work well in beginning investors' portfolios.
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What is a dividend stock?
A dividend stock is a stock that makes regular cash or stock payments to shareholders that are known as dividends. Most dividends are paid in cash, and most dividend-paying companies choose to pay their dividends on a quarterly basis -- however, monthly, semiannual, and annual dividends aren't particularly rare.
To illustrate this with a real-world example, General Motors (NYSE: GM) stock is trading for approximately $44 per share as I write this. The company pays a dividend of $1.52 per share annually, broken up into quarterly installments of $0.38. So, if you own General Motors stock, you can expect to receive a cash payment of $0.38 every three months for each share that you own.
Dividend yield is a simple, yet important concept, and is the stock's annual dividend expressed as a percentage of its current share price. In our General Motors example, this can be found by dividing $1.52 by the $44 share price, which reveals a dividend yield of about 3.5%.
Why many companies pay dividends
There are three main ways companies can use their profits : They can reinvest in the business, buy back stock, or pay dividends to shareholders. And many companies do a combination of two, or even all three of these things.
Reinvesting back in the business can be essential for growth, as well as for maintaining a competitive advantage, so most companies reinvest at least some of their profits back into the business. In fact, many fast-growing companies pay no dividends at all.
The two main ways of returning capital to shareholders, buybacks and dividends, each have their own advantages and drawbacks.
Buying back stock reduces the number of outstanding shares, making the remaining shares more valuable as a result. For example, if a company has a market capitalization of $10 billion and has 100 million outstanding shares, each share would be worth $100. If the same company buys back 10 million of those shares, there would only be 90 million left, and each would be worth about $111.
Plus, buybacks can be beneficial from a tax perspective. If you own stock in a standard (taxable) brokerage account, the dividends you receive are generally taxable in the year in which you receive them. On the other hand, you don't pay tax on stock price gains until you sell your shares.
Dividends have the advantage of putting money directly back into shareholders' hands. This option gives investors the most control over their money -- they can choose to use the dividends to cover living expenses, reinvest them in more shares of the same stock, or use them to invest elsewhere.
What makes a dividend stock great for beginners?
When it comes to dividend investing, it's a good idea for beginners to start out with a core of rock-solid dividend stocks that are unlikely to be too volatile or unpredictable.
There are a few things beginning investors should look for when choosing their first dividend stocks:
- Consistency: Check to see if the company has a long history of paying dividends, and also see whether there have been dividend cuts or missed payments in the past. For example, a lot of companies were forced to slash or even eliminate their dividend payments during the Great Recession in 2008 and 2009 as profits fell. There are several reasons a company could decide to cut its dividend (trouble making debt payments, increased pricing pressure from competitors, etc.), so you want to find companies that aren't too vulnerable to many profit-destroying problems.
- Sustainability: A solid track record of making dividend payments is a good indicator that a company will continue to do so, but there are some other ways to help determine if a company's dividend is sustainable. For example, is the company paying out too much of its earnings in the form of dividends (more on that in a bit)? Does the company carry lots of debt? Is there an identifiable competitive advantage that should allow the company to maintain its market share for years to come?
- Low volatility: As a beginner, you probably don't want dividend stocks that are going to climb and fall by a dramatic amount every day. Stock volatility is expressed using a metric known as beta , which can be readily found in most stock quotes. In a nutshell, a beta of exactly 1 means that a stock has average volatility. A beta of less than 1 means that a stock is less reactive to market moves than the average stock in the S&P 500 , while a beta of more than 1 indicates above-average volatility. For your first few dividend stocks, sticking with lower-beta companies is a smart idea.
- A track record of growth: A good dividend stock has consistency, sustainability, and low volatility. A great dividend stock has all of these traits, plus the ability to grow over time, both in terms of its share price and its dividend. For example, one of the stocks I'll discuss later on has increased its dividend more than 90 times in less than 25 years with no cuts or missed payments whatsoever and has also seen its share price rise more than 550% over that time. Dividend Aristocrats -- a group of S&P 500 stocks that have increased their dividends for at least 25 consecutive years -- are a great starting point for new dividend investors.
Five key metrics beginning dividend investors should know
There are literally hundreds of investing metrics that can be used, but there are some that are more important than others, especially when you're just getting started. These five metrics, in particular, can help you understand and evaluate your dividend stocks better.
- Yield: Most stock quotes do this calculation for you, but if you're curious, a stock's dividend yield is simply its annual dividend rate divided by its current share price, expressed as a percentage.
- Payout ratio: The payout ratio is an important metric when it comes to the sustainability of the dividend. The payout ratio tells you how much of a company's earnings are being paid out as dividends, and is calculated by dividing the company's current annual dividend rate by its last 12 months' worth of earnings. A high payout ratio -- especially one above 100% -- could be a sign that a dividend cut is on the horizon.
- Beta: I touched on beta earlier, but it's worth mentioning again. Beta is included in most comprehensive stock quotes, and while the mathematics behind it are beyond the scope of this article, it is a measure of a stock's volatility relative to the benchmark S&P 500 index. As an example, General Motors' beta is 1.7, so this implies that for every 1% change in the S&P 500, General Motors can be expected to move by roughly 1.7%. This can help manage investors' expectations of how much fluctuation they might see in their portfolios.
- Free cash flow: If you aren't completely new to investing, you've probably heard the term "earnings." I actually just referenced earnings when discussing payout ratio. One problem with earnings, or net income, is that is can often be distorted, especially if a company makes a big acquisition or disposes of a major asset. For example, if a company earns $20 million from its normal business operations and makes another $30 million from selling one of its warehouses, it looks (on paper) like the company made $50 million. However, this figure doesn't represent the company's sustainable income. On the other hand, free cash flow (available on a company's cash flow statement) is a relatively simple metric that tells you how much cash is flowing into a company minus the cash that's flowing out. From a dividend investor's perspective, this tells you if a company is bringing in enough net cash to be able to cover its dividend payments.
- Debt-to-equity ratio: Companies with heavy debt loads tend to get into trouble quicker when conditions get tough. On a company's balance sheet, you can find its outstanding debts, as well as its shareholders' equity. Dividing the two gives you the debt-to-equity ratio . This metric is most useful for comparing the debt levels of companies within the same industry to determine if unusually high debt obligations exist. When times get tough, companies with lots of debt are often the first to cut their dividends (and get into other financial trouble), as debt servicing eats up a greater percentage of profits.
Three important dividend investing concepts
Before we dive into some great dividend stocks for beginners, here are a few other dividend investing concepts that are important for beginners to understand.
- It's not just about yield. One important concept for beginners is that of a dividend yield trap . This term refers to stocks with unusually high dividends, but because of some fundamental flaw. Perhaps the company is taking on excessive debt to generate returns, or is paying out an unsustainable percentage of their earnings. All things being equal, higher yields are nice, but it's important to be sure that a stock's dividend isn't high for the wrong reasons.
- Know when you'll get paid. Your brokerage account probably has several dividend dates listed, but there are only two that you really need to pay attention to. The ex-dividend date is the first day the stock trades without its next dividend included in the price. In other words, if you buy the stock before the ex-dividend date, you're entitled to the dividend payment. If not, you'll have to wait for the next one. The pay date is the day you should actually expect the dividend to show up in your brokerage account, and it's generally some time after the ex-dividend date.
- Enroll your dividend stocks in a dividend reinvestment plan (DRIP) for maximum potential. I could write a long article just about dividend reinvestment (and I have), but the simple version is that instead of you receiving cash, a DRIP automatically reinvests your dividends in more shares of the same stock, allowing your investment to compound over time. DRIPs have some big advantages, such as no trading commissions on your reinvested dividends and the ability to buy fractional shares of stock, so they are often the best move for long-term investors.
Three great dividend stocks for beginners
To be clear, there are literally hundreds of stocks that could be excellent choices for beginning investors, so it's not practical to try to list every good option here.
Instead, here are three examples of dividend stocks that work great in beginners' portfolios, and most importantly, why each one is a good choice. Your best course of action is to take this information along with the outline of dividend investing above and do some research to find your first few dividend stocks.
Company (Ticker Symbol)
Toronto-Dominion Bank (NYSE: TD)
Realty Income (NYSE: O)
Walmart (NYSE: WMT)
Data source: TD Ameritrade . Prices and yields as of June 8, 2018.
A rock-solid bank with room to grow
It's tough to find any stock with a longer dividend history than Canada-based Toronto-Dominion Bank, better known as TD Bank. The financial giant has paid dividends since 1857 -- before the Civil War!
TD is the fifth-largest bank in North America by assets and has grown rapidly over the past couple of decades, both organically and through acquisitions such as New Jersey-based Commerce Bank and the credit card portfolios of Chrysler Financial, MBNA, and Target . The majority of the bank's business still comes from Canada, where the bank has the No. 1 or No. 2 market share in most areas of retail banking.
If you aren't familiar, Canada has a remarkably stable banking system, with no significant banking crises since the 1800s. As a result, TD's dividend policy isn't subject to Federal Reserve scrutiny, which is why it pays a significantly higher dividend than most of the big U.S. banks and has a strong history of dividend increases -- even during the financial crisis. It also makes TD an ideal candidate for beginning investors, thanks to its history of responsible management.
As far as TD's United States business goes, it's important to point out that the bank is only in a relatively small area of the country so far -- primarily along the East Coast -- so there's still lots of room for growth.
It's tough to beat this dividend track record
I've written before that Realty Income Corporation is perhaps the best overall dividend stock in the market, and I'm standing by that statement.
Realty Income is a real estate investment trust (REIT) that specializes in single-tenant retail properties. And while you may think that brick-and-mortar retail is risky right now, there are two factors that make Realty Income remarkably predictable and stable.
First, the company only invests in certain types of retail properties -- specifically, those that are resistant to both e-commerce headwinds and recessions. For example, drugstores make up a large chunk of the company's portfolio, and these businesses sell things people need in a timely manner. Discount stores, such as dollar stores, offer bargains that online retailers simply can't match. And service-based retail, like fitness centers, is naturally immune from online competition for obvious reasons.
Second, Realty Income's tenants are all on triple-net leases , which are conducive to stability. A triple-net lease usually has a long initial term (15-20 years), with annual rent increases built right in. Plus, the tenants have to cover the variable costs of property taxes, insurance, and building maintenance. All Realty Income has to do is get a tenant in place and enjoy over a decade of predictable income. The company's latest results show just how well the business continues to perform, even in the challenging retail environment.
As a result, the company has built a terrific track record . Realty Income has paid 574 consecutive monthly dividends and has increased its payout more than 90 times since its 1994 NYSE listing. What's more, because of increases in the underlying property values, it has produced a staggering 15.7% annualized total return since that time.
A wide-moat retailer that can go toe-to-toe with Amazon
As I discussed in the previous section, there are certainly some areas of retail that should be avoided. However, one that I mentioned as a strong area of retail is discount-oriented retail, and there's no better-positioned discount retailer to invest in than Walmart. In fact, I'd go so far as to say that Walmart is doing the best job of any major U.S. brick-and-mortar retailer when it comes to competing against e-commerce rivals like Amazon .
Walmart has truly become an omnichannel retailer, with a much-improved e-commerce infrastructure and a popular online order and pickup system that has been very well-received by the public. If anything, I'd say that Walmart's vast physical footprint gives it somewhat of an advantage over Amazon in many ways. Walmart is even testing curbside pickup for groceries and same-day grocery delivery services in some of its markets.
The results are strong so far. Walmart's digital sales grew by roughly 50% year over year in three of the four quarters of 2017. In fact, the company's CEO recently said that digital sales are expected to grow by another 40% year over year in 2018.
In a nutshell, Walmart is now a dual-threat retailer. It maintains its historic competitive advantage of being the lowest-priced physical retailer its customers could go to, and now has a formidable e-commerce presence as well.
As far as the dividend goes, Walmart's 2.5% dividend yield doesn't exactly make it a "high dividend" stock, but keep in mind that the payout has been increased for an impressive 43 consecutive years and represents just over 40% of the company's earnings, so there should be plenty of room for future increases, especially if the company's online strategies continue to pay off.
Risks and drawbacks of dividend investing
It's very important for new investors to understand what they're getting into. So here are a few things that new dividend stock investors need to keep in mind.
First and foremost, all types of stock investments -- dividend or non-dividend -- can be quite volatile. I'll spare you the statistics lesson , but based on the market's historical performance, "usual" market swings range from a loss of about 23% to a gain of more than 45% in a single year . For this reason, it's generally not a good idea to invest in stocks (even rock-solid dividend stocks) with money you'll need within the next few years.
Second, dividend stocks tend to be particularly sensitive to interest rate fluctuations. To make a long story short, as yields rise on risk-free income investments like U.S. Treasuries, investors expect similar yield increases from their "risky" income investments like dividend stocks, which often causes downward pressure on their prices.
Additionally, many new investors don't realize dividends are taxable. Unless you hold your dividend stocks in a tax-advantaged account like an IRA, the dividends you receive can result in a higher tax bill. While most dividends qualify for lower tax rates than ordinary income, it's important to understand that dividends are not tax-free income. This is even true if you choose to reinvest your dividends through a DRIP.
Invest with a "forever" mentality
One of the best Warren Buffett quotes that new investors can learn from is, "Our favorite holding period is forever."
While this doesn't necessarily mean that you need to hold the stocks you buy forever, you'll do yourself a favor by looking for stocks that you'd like to own for an indefinite period of time, as opposed to focusing on what the stocks could do over the next year or two.
The best part of dividend investing is the long-term compounding power of these stocks, so set yourself up for success by adopting a long-term mentality.
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John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Matthew Frankel owns shares of GM, Realty Income, and The Toronto-Dominion Bank. The Motley Fool owns shares of and recommends AMZN. The Motley Fool has a disclosure policy .