Why Dividend Stocks Can be Beneficial to Investors

The stock market is commonly known as an avenue where fortunes are made but also where tremendous losses can be found. Regardless of the investment type, there potentially is the risk of seeing multiple substantial declines throughout an investment's lifetime. Though, investors should not turn away from investing altogether.

What are Dividend Stocks?

Dividend stocks are stocks of companies that make distributions to their shareholders on a monthly, quarterly, or yearly basis, usually by paying out with cash. The yield varies depending on the company and the industry it operates. For instance, a tech company is less likely to pay dividends as they typically reinvest in the core business to grow. However, an established financial institution is more likely to pay dividends because it has more consistent cash flows.

The dividend yield is one of the first financial metrics an investor sees. It's important to note a higher yield doesn't necessarily mean better. A higher yield can indicate various things, such as significant downward pressure on the share price due to reduced shareholder confidence. Simply put, as the share price falls, presumably due to worsening fundamentals, the yield of the dividend will be greater. The dividend may be at risk of a dividend cut, too.

A portfolio of dividend-focussed companies that have solid historical track records and consistent net income is what many consider volatility hedges. Instead of shareholders experiencing returns through asset appreciation, they instead receive cash. Dividends are useful since they provide income throughout market declines and economic hurricanes. The dividends can be used to repurchase shares of the same or different companies to increase the size of the portfolio. However, this income can assist in other areas, including personal finance.

How do Dividends Work?

Now that we understand what dividends are, it's crucial to understand how they work.

Payment periods vary by company. Dividends can be ever so complicated for new investors, particularly if they don't acknowledge dates. The ex-dividend date states the previous day when an investor must become a shareholder to be eligible to receive the dividend. If the dividend date has passed and shares are purchased, it will not pay that periodical dividend payment to the shareholder.

Dividends don't appear everywhere. At the risk of sounding satirical, it's a tough decision for a company to take the initiative of rewarding its shareholders. Dividends are expensive and can absorb a large part of a company's earnings, leaving little to reinvest into the business. Investors can understand the logistics of dividend payments through the payout ratio. The payout ratio measures the amount of net income paid to shareholders in terms of percent.

Generally, a payout ratio of 75% is acceptable. However, less than that figure is ideal. Excess capital is freed-up for the business to use, either for growth or to be used as a safety net. There are instances where companies have a payout ratio over 100%, meaning they are using their existing cash or borrowing cash to pay shareholders.[1] As the company borrows more to pay its shareholders, the burden of debt would continue to build. Eventually, the company may have to stop paying dividends altogether to prevent a collapse. Such actions are not sustainable and can jeopardize an investor's returns in the long run.

What Makes a Good Dividend Stock?

As mentioned, a low payout ratio can indicate a company's dividend safety. Although, there's much more to account for, such as the history and growth of the dividend.

Dividend aristocrats are companies that have increased their dividends for 25 years consecutively, and dividend knights for 50 years. Many publicly-traded companies strive to obtain this label since it shows stability and reliability to investors. Such track records demonstrate the company's ability to reward shareholders in unpredictable periods.

Dividend growth is important for a couple of reasons. As the company expands, and the market capitalization increases, the dividend yield will shrink. To prevent this, the company will typically raise its dividend to keep the incentive for shareholders to remain invested. Secondly, inflation can eat away at the buying power of each payment. Consistent dividend increases signal to investors that the company is well-positioned for continued profitability over the long term.

Lastly, but most importantly, the company should have minimal debt in contrast to its assets—regardless of the industry it operates within. If a company is overleveraged, a dividend cut could be possible in the future. Rising interest rates in particular can make a once-great company look unappealing. As required debt payments increase, the dividend payout ratio will likely surge higher.

The Pros

The first positive of dividend investing is relatively consistent income. Returns from dividends over long periods can soften the volatility of the equity markets. Additionally, investors are less likely to be shaken up by macroeconomic fears circulating in investment forums.

Secondly, inflation protection. While investing can certainly form generational wealth, inflation can deteriorate a portion of it. Dividends can help hedge against deteriorating buying power.

The Cons

The adage goes, "only two things are unavoidable, death and taxes." Unfortunately, dividends don't stray from taxes—or the eventual death of the company. By investing in non-dividend-paying stocks, investors can avoid the burden of paying taxes on dividend income.

Lastly, dividends aren't guaranteed. While historical track records and predictable earnings trends may be promising, there is still a fair chance the dividend gets cut or worse. Depending on the company's operating status, financial situations and cash flows.

Key Takeaway

Dividend stocks can be solid investment tools to generate long-term wealth. Given the current macroeconomic environment, it's certainly an appealing alternative. However, not all companies offer this reward to shareholders. Depending on the cyclicality of the dividend payment, investors will need to keep a close lookout for ex-dividend dates to ensure they are eligible to receive it.

Importantly, companies that offer high dividend yields are not necessarily better than others. Investors need to note the importance of dividend safety, as measured through the payout ratio, dividend history, and minimal debt presence on a balance sheet. Overall, the positives of dividend stocks make a compelling investment strategy for long-term investors.

The high dividend ranking function of the moomoo trading app can help users quickly identify high dividend paying stocks in the market. Users can filter the list by dividend yield, dividend, price, or market capitalization. Besides, users can also find out the historical dividend distribution plan of the individual stock. Sign up and download the moomoo app today to get free access to view the high dividend ranking list.

Images provided are not current and any securities are shown for illustrative purposes only.

[1] https://www.dividend.com/dividend-education/what-is-an-ideal-payout-ratio/