1. Introduction To Dividends: Introduction
  2. Introduction To Dividends: Terms To Know And Other Basics
  3. Introduction To Dividends: Dividend Dates
  4. Introduction To Dividends: Investing In Dividend Stocks
  5. Introduction To Dividends: Doing Your Homework And Taxes
  6. Introduction To Dividends: Conclusion

Like any other investments, it’s important to perform due diligence prior to making any dividend stock-related decisions. Keep in mind, when evaluating investments, it’s important to compare individual companies against industry averages or other similar companies as opposed to unrelated companies – this makes for a more meaningful comparison. To get you started, here are several factors to consider when researching and selecting dividend stocks, including the dividend yield, dividend cover ratio, dividend payout ratio and the company’s history of dividends.

Dividend Yield

As mentioned earlier, dividend yield shows how much a company pays in dividends each year relative to its share price. It’s calculated by dividing the annual dividend per share by the price per share.

It would make sense that the higher the dividend yield, the better the investment, but this financial ratio can be deceptive. Remember that dividend yield increases as share price drops. A dividend yield that is unusually higher than other stocks in the same industry may indicate that the stock’s price may drop or that future dividends will be cut or eliminated.  This can spell double-trouble for investors who will lose money both on the falling stock price and the loss of any future dividend income. In general, many investors focus on stocks whose dividend yields fall in the 2% to 5% range – the average range of S&P 500 stocks over the past six decades.

Dividend Cover Ratio

The ratio between a company’s earnings and its net dividend to shareholders is known as dividend cover. This ratio helps investors measure if a company’s earnings are sufficient to cover its dividend obligations, as well as determine how sustainable a dividend is. It’s calculated by dividing earnings per share by the dividend per share:

 

 

Figure 4: How to calculate dividend cover.

Here’s an example. Financial ratings and analytics company S&P Global (SPGI) has an earnings per share of $8.58 and pays an annual dividend of $1.64 per share (as of Oct. 15, 2017). Its dividend cover, then, is 5.23. Meanwhile, global healthcare giant Johnson & Johnson (JNJ) has an earnings per share of $5.91 and pays an annual dividend of $3.36 – so its dividend cover is 1.76. But what do these figures mean?

In general, a cover ratio of 2 or 3 shows adequate cover and that the company can afford to pay a dividend. If the ratio falls below 2, it might indicate that a dividend cut is on the horizon. If the ratio falls below 1, the company is likely using last year’s retained earnings to cover this year’s dividend. A higher dividend cover (say, 4 or 5) can be viewed favorably as a sign the company has some cushion against future downturns. Covers much higher than that, however, and investors may feel that the company is holding out on them and could have paid a higher dividend. (For a closer look, see What is the Formula for Calculating Earnings Per Share?) [L4]

Dividend Payout Ratio

The inverse of the dividend cover ratio is the dividend payout ratio. It indicates the percentage of earnings a company pays out in cash dividends. It’s calculated by dividing dividend per share by earnings per share:

 

Figure 5: How to calculate the dividend payout ratio.

Using our previous example, SPGI would have a dividend payout of 19% ($1.64 DPS / $8.58 EPS), and JNJ’s payout would be 57% ($3.36 DPS / $5.91 EPS). In general, a company that pay out less than 50% of its earnings in the form of dividends is considered stable – these companies have the potential to raise earnings over the long term. If a company pays out more than 50%, it may not raise its dividends as much as companies with lower payout ratios, and it may have trouble maintaining dividends over the long run. (To learn more, see 4 Ratios to Evaluate Dividend Stocks.)

Continuous Records

Companies that boast consistent dividends, particularly if they increase over time, are typically financially stable and well-managed companies. While a good track record does not guarantee future results, a company that has performed well in the past may be less risky than one with a spotty or inconsistent history.

That said, any dividend-paying company has to pay its first dividend at some point, and companies with excellent fundamentals sometimes wait to begin paying dividends – much longer than investors would like them to. Take multinational tech firm Microsoft Corp. (MSFT), for example. It didn’t start paying a dividend until February of 2003, nearly 17 years after its March 13, 1986 initial public offering (IPO).

Online Research Tools and Screeners

Today’s dividend investors have access to plenty of print and web-based resources, research tools and screeners to help explore and evaluate dividend stocks. You may have to pay a small fee for premium content such as certain proprietary dividend ratings systems; however, much of your research can be performed at no cost to you – other than the time needed to do your homework.

Certain websites offer dividend screeners that allow you to screen dividend stocks based on a variety of inputs, such as industry/sector, market cap, price and dividend payout, dividend frequency and history, or by a specified ex-dividend date range.  The screeners search based on your specified inputs and display a list of dividend stocks that match your criteria, including information such as ticker symbol, dividend yield, current price, annual dividend, ex-dividend date and pay date.

It is important to remember that investing in any stock – whether or not the company pays a dividend – is not a risk-free investment. In addition to researching on the front end, you should always monitor your investments and consult with qualified tax and investment professionals when necessary.

Taxes

Any company that pays you a dividend of more than $10 must provide you with IRS Form 1099-DIV, Dividends and Distributions. Box 1a shows ordinary dividends; Box 1b shows qualified dividends, and Box 3 shows non-dividend distributions. [Note: it’s your responsibility to report all taxable dividends even if a company fails to send you this form.]

The amount of tax you owe on dividends depends on your overall income and whether the dividends are qualified or nonqualified (also called ordinary dividends). Qualified dividends, which are subject to capital gains tax rates (currently a maximum of 20%), are dividends that:

  • Are paid from a domestic (U.S.) company or a qualifying foreign company
  • Are not listed with the IRS as a dividend that does not qualify
  • Have met the required dividend holding period

You’ll owe the higher tax rate (the one applied to ordinary income) on income from nonqualified dividends – those paid by real estate investment trusts (REITs), master limited partnerships (MLPs), those on employee stock options and those on tax-exempt companies. (For a closer look, see How are Qualified and Nonqualified Dividends Taxed?)

You’ll report dividend income on your tax return. Ordinary dividends are reported on Line 9a of Form 1040 or 1040A; qualified dividends are reported on Line 9b. You must complete Schedule B if you have received more than $1,500 in ordinary dividends. Depending on your situation, you may have to file additional forms and schedules with your tax return.

If your dividends are significant, you may have to pay estimated taxes to avoid interest and/or penalties (the federal income tax is a pay-as-you-go tax, meaning that taxes must be paid as you receive income throughout the year). In general, if you expect to owe tax of $1,000 of more, you should make quarterly estimated tax payments. Individuals can file Form 1040-ES, Estimated Tax for Individuals along with the appropriate state’s estimated tax form. Alternatively, you may be able to submit a new Form W-4 to your employer to change your withholding allowances (so that more money is withheld each pay period).

Taxes are complicated and tax laws do change. It’s recommended that you work with a qualified tax specialist or CPA to determine the most favorable approach to taxes. (For more, see Understanding How Dividends are Taxed.)


Introduction To Dividends: Conclusion
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