About Dividend Stocks

Many investors enter the stock market intending to build wealth rapidly and as a result, they often invest purely in growth stocks in an attempt to get rich quickly, and they can overlook the advantages of investing in dividend stocks, which can often prove more profitable in the long-term. So, what is a dividend stock and what are the advantages of investing in dividend stocks?

A dividend stock is a company that pays out regular dividends to their investors. A typical dividend stock is normally a mature company with a track record of distributing earnings/profits back to its shareholders.

As an investor in a dividend stock, you’ll receive a portion of the company’s profits, either in cash or shares. More established companies typically choose to pay a proportion of their profits to shareholders through a regular dividend. Whereas fast-growing companies will often reinvest their profits to generate further growth.

At first glance, dividend payments may seem insignificant in the short term. However, over the long term, dividends can generate considerable investment returns and contribute to the long-term profitability of your portfolio.

Dividends for generating passive income

Dividends can offer a way of building a passive income stream. This means that, while a share price might fluctuate with the markets, you will still be earning additional income via the regular dividend pay-outs. Many dividend stocks currently yield over 4% (sometimes much higher) and a well-constructed portfolio of dividend stocks can generate an impressive income stream over time. As a means of creating additional income, investing in dividends can offer considerably higher returns than the interest on a regular savings account.

Additionally, regular cash dividend payments can also be reinvested back into a dividend stock to take advantage of compound interest. Compounding is the process of generating earnings on previous reinvested earnings, over time this can result in the accelerated growth of your portfolio. Effectively, by reinvesting dividend payments instead of withdrawing them, you are creating an additional income stream over and above the stock’s share price growth. This passive income stream can help you meet your long-term investing goals.

Dividend stocks can also help protect your portfolio during times of market volatility as dividend stocks tend to be less sensitive to the market than growth stocks. Companies that pay dividends are usually well-established firms with strong track records. As such they can are often considered safer than growth stocks during periods of market volatility or economic stress.

There are however traps to look out for with certain dividend stocks. The rule of thumb when seeking out income stocks is not to be tempted by ‘dividend traps’. Just because a share offers a very high dividend, it doesn’t necessarily mean that it’s a sound investment.

A rise in a share’s yield is often the result of a falling share price. This can mean that a company is in danger of cutting its pay-outs, or that it’s unlikely to grow its pay-outs further from their already lofty levels.

During the recent financial crisis many companies cut their dividends or even stopped pay-outs altogether. But even in more stable market conditions, there are plenty of signs to watch out for. When a company issues a profit warning it can be a sign that its dividend could be in danger. Also, if a firm’s dividend is considerably higher than its competitors’ pay-outs, this could be a sign that all is not well.

What You Should Look For

Do your research and check if a company’s earnings and revenues are growing and, importantly, ensure it’s not overly laden with debt. These factors have an impact on dividend pay-outs. You should also seek out firms that are set to increase their future pay-outs. When a company’s earnings and profits are rising, it is more likely to be able to raise the dividend because there is more cash available to return profits to their investors.

If you’re looking at a share for its income potential, always check its dividend cover to see how wide the gap is between the dividend and earnings; the wider the gap, the more room a firm should have to maintain its dividend if revenues and profits begin to struggle. You want to be able to determine how robust and reliable a company’s shareholder pay-outs are going to be in the future.

So, research information on earnings, revenues, dividends and debt. This information is available in company reports and on financial websites. Look at each potential investment on a case-by-case basis and examine the competitive advantage that one company has over its peers, and certainly assess whether or not the dividend is sustainable in the years ahead.

And, as always, remember that past performance does not guarantee future performance, so research well and take professional financial advice where possible.

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