Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Don't Buy A Dividend Stock Unless You Know These 10 Things...

There aren't many things you can buy that automatically give you your money back.

Think about it: When was the last time your car wrote you a check?

Has the gas station ever sent you money?

What about the shoe store?

Well, there is one thing you can buy that will give back: dividend stocks.

Dividend stocks are stocks of companies that give a portion of their quarterly profits back to shareholders, and this is very attractive to investors who want a stream of income that doesn't involve working for The Man. This is exactly what my colleague Amy Calistri writes about in her Daily Paycheck newsletter, which helps thousands of investors every month with cashing in on lucrative quarterly, even monthly, dividend checks.

Not all dividend stocks are created equal, though, as Amy will be the first to tell you.

There are a few terms you need to know before you buy yourself one of these gifts that keep on giving. You can find these and more in our Financial Dictionary, with its thousands of easy-to-understand terms.

Qualified Dividend Versus Ordinary Dividend

A qualified dividend is a dividend eligible for capital gains tax. Capital gains taxes are usually lower than ordinary income taxes, which means that qualified dividends can save you money. An ordinary dividend is a dividend that is not eligible for capital gains tax.

In order to be a qualified dividend, the dividend must come from an American company (or a qualifying foreign company), must not be listed as an unqualified dividend with the IRS, and must meet a required holding period. In general, the holding period is at least 60 days for common stock, 90 days for preferred stock, and 60 days for a dividend-paying mutual fund.

Cumulative Dividend

A cumulative dividend is a dividend, usually on preferred shares, that must be paid before any other dividends on the issuer's other securities. Preferred stock that doesn't carry a cumulative dividend is called "straight preferred." Cumulative preferred often has slightly higher rates of return than straight preferred because cumulative preferred carries the risk of not receiving regular dividends.

For example, let's assume Company XYZ issues preferred stock with a $1-per-share cumulative quarterly dividend. Company XYZ also has common stock with a $0.50-per-share dividend.

Now let's assume Company XYZ's cash flow takes a hit and the board suspends dividend payments. Because the preferred shares have a cumulative dividend, once Company XYZ resumes its dividend distributions, it must first "catch up" on the missed dividends payments to the cumulative preferred before it pays dividends to the common stock. It must do this even if it does not completely suspend the preferred dividends; reducing them creates a similar obligation.

Stock Dividend

Dividends don't always come in cash; sometimes they're in the form of more shares.

For the company, stock dividends are a way to avoid using cash, and for the investor they are a lot like doubling down on an investment. It is important to note, however, that stock dividends increase the number of shares outstanding, which can affect earnings per share. Most cash dividends are quarterly, but stock dividends are generally paid at infrequent intervals.

Dividend Yield

Dividend yield is a stock's dividend as a percentage of the stock price:

Dividend Yield = Annual Dividend / Current Stock Price

Note the inverse relationship: If the stock price rises, the yield goes down, and vice versa.

Dividend yields measure an investment’s productivity, and some even view it like an interest rate earned on an investment. They can also signal when to sell an investment. For example, if Company XYZ stock rises and its dividend yield falls to, say, 2%, you might consider selling the shares and reinvesting the money in another stock with a 10% yield, which would increase your annual dividend income.

Declaration Date, Record Date, Ex-Dividend Date

Here's generally how a dividend is born. First, the board of directors reviews the company's financial performance and cash availability and decides to declare a dividend (usually via press release). The day they declare the dividend is called the declaration date. The declaration will also state that only shareholders who own the stock on a particular date (the record date) will receive the dividend.

After the company sets the record date, the stock exchanges or the National Association of Securities Dealers (NASD) assign the ex-dividend date (typically two business days before the record date). On the ex-dividend date, the share price declines by the value of the dividend paid. The payable date is the date on which a company actually pays the dividend.

Dividend Reinvestment Plan (DRIP)

Many people love the efficiency of automation, even when it comes to some forms of investing. One of the best examples is participation in a dividend reinvestment plan (DRIP), which allows investors to automatically use a company's dividends to buy more of the company's stock, often at a discounted price. For instance, a $1.00 dividend payment will buy you a quarter of a share of a $4.00 stock.

DRIPs were originally company-sponsored programs for employees, but today, hundreds of companies offer DRIP plans to anyone, and they're a great way to turn a few dividend-paying shares into a lot of dividend-paying shares without much effort.

Dividend Capture Strategy

A dividend-capture strategy is the act of purchasing a security for its dividend, capturing the dividend, and then selling the security to buy another one about to pay a dividend. By doing this, investors receive a steady stream of dividend income instead of waiting for an individual holding to pay its regular dividend.
 
For example, instead of buying a stock and waiting all year for four quarterly dividend payments, the investor would buy the stock before its ex-dividend date and sell it 61 days later. Then he would plow the money into another company that is about to pay a sizable dividend. Assuming a 61-day holding period, this investor would pocket six dividends during the year (365 days divided by 61 equals 6) instead of four -- that's 50% more dividends from the same dollars!

The Investing Answer: Dividend stocks are indeed a gift that keeps on giving, but always understand what kind of dividend you're receiving and don't stop looking at your investments just because they pay dividends. You can always ask your broker or financial advisor about the ins and outs of a particular stock's dividends, but if you want it straight from the horse's mouth, you can find everything you need to know about a company's dividend on the investor relations section of the stock issuer's website and even in its 10-Q or 10-K (usually near the end). Also, be sure to sign up for press release alerts from your favorite companies--then you'll find out what's happening with a dividend when the rest of Wall Street does.

P.S.: My colleague Amy Calistri truly believes the dividend check is the gift that keeps on giving. That's why she has developed what she calls the "Dividend Trifecta Strategy," and it just might be the key for regular investors who want to secure a large and steady stream of dividend income right now. Go here to learn more.