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Successful dividend investing: Investment goals, analysis of dividend stocks, dividend sustainability, tax considerations & long-term perspective
Are you looking to achieve financial independence through dividend investing?
Discover the secrets to successful dividend investing and unlock the potential of passive income with our comprehensive guide.
Discover the secrets to successful dividend investing and unlock the potential of passive income with our comprehensive guide.
QUOTE
"Do you know the only thing that gives me pleasure? It's to see my dividends coming in."
Big ideas
- Prioritise financially strong and stable companies over companies with big growth prospects.
- Give importance to companies that have a track record of increasing their dividends over time, demonstrating a commitment to shareholders.
- Adopt a patient and long-term approach, reinvesting dividends to benefit from the power of compounding over time.
Rules for successful dividend investing
When it comes to achieving financial success through dividends, whether or not you follow some essential rules can significantly impact your results. By following these guidelines, you can set yourself on the path to building a strong dividend portfolio and maximising your returns.
- Go with stability and authority companies
- Setting clear investment goals
- Look for companies with a history of paying dividends
- Focus on dividend growth from a long-term perspective
- Pay attention to the dividend yield
- The importance of the payout ratio for successful dividend investing
- Conduct fundamental analysis of dividend stocks
- Constantly identify reliable dividend stocks
- Assessing dividend sustainability
- Dividend reinvestment and compounding
- Diversification of your dividend portfolio and risk management
- Tax considerations
Successful dividend investing: Quality vs quantity
There is an age-old debate of quality versus quantity when it comes to picking your dividend stocks. The choice is quite simple, stocks with higher dividends that might not last or stocks with lower dividends that will probably stick around.
You just need to strike the right balance between the allure of high-yielding stocks and the stability offered by reliable dividend payers.
Ultimately, you should prioritise companies with a history of reliable dividend payments. These are often well-established, financially sound companies with proven track records. Their dividends may not be the highest in the market, but they are more likely to be sustainable and less susceptible to getting cut when times are tough.
You just need to strike the right balance between the allure of high-yielding stocks and the stability offered by reliable dividend payers.
Ultimately, you should prioritise companies with a history of reliable dividend payments. These are often well-established, financially sound companies with proven track records. Their dividends may not be the highest in the market, but they are more likely to be sustainable and less susceptible to getting cut when times are tough.
The temptation of high yields
Of course, high yields are pretty tempting with the promise of attractive returns. There are always some bargains to be had where the dividend is disproportionately high relative to the stability of the company. But such opportunities should definitely be approached with caution, though. In some instances (arguably more often than not), excessively high yields are a red flag signalling potential risks or financial instability within the company.
The pitfalls of unsustainable dividends
Some companies may artificially boost their dividend yields to attract investors, but this is normally unsustainable in the long run. It is crucial to conduct thorough research and analyse the company's financial health, growth prospects, and dividend history to ensure that the high yield is not merely a short-lived enticement.
Consider the following rules of highly effective dividend investors
Investing in stable and authoritative companies is a cornerstone of successful dividend investing. These companies have a proven track record of weathering market challenges and consistently delivering returns to their shareholders. Prioritise well-established blue-chip stocks with robust financials, strong market presence, and a history of reliable dividend payments.
2. Setting clear investment goals
Before you even think about buying some shares, write down your goals that fit your financial aspirations and be honest with yourself about your own risk tolerance. Typical objectives are to generate passive income, achieve long-term growth, or fund a specific financial milestone. You will be surprised how often you will fall back on a list of well-defined goals to guide your investment decisions and keep you on track.
3. Find companies with a long history of paying dividends
It makes intuitive sense that if a company has done something well in the past, it can do so again. Likewise, a company that has never done something is less likely ever to achieve it. So investing in companies with a consistent history of paying dividends is just prudent. By paying out over time, these companies have shown their commitment to shareholders. Usually, the consistency in dividend payout is matched by their ability to generate steady cash flow, which allows them to reward investors, even during a downturn in fortunes.
In the Trading 212 app, there is a specific group of stocks that have a reputation for maintaining a good track record of dividend payouts. Tap the ‘search’ icon, and you’ll see it there. Don’t follow it blindly, but it can be a good start in your search for similar trading instruments.
In the Trading 212 app, there is a specific group of stocks that have a reputation for maintaining a good track record of dividend payouts. Tap the ‘search’ icon, and you’ll see it there. Don’t follow it blindly, but it can be a good start in your search for similar trading instruments.
4. Focus on dividend growth in a long-term perspective
Embrace a long-term perspective when selecting dividend stocks. Companies prioritising dividend growth are more likely to provide a growing income stream and potentially higher total returns. Focus on the company's ability to increase dividends over time rather than just the current yield.
5. Pay close attention to dividend yields
While not the sole determinant of a good investment, the dividend yield remains an essential metric for dividend investors. The yield represents the dividend income as a percentage of the stock price. Consider a healthy balance between dividend yield and dividend growth to optimise your dividend portfolio.
Data comparing the performance of dividend yield and dividend growth
Using data from the Center for Research in Security Prices (CRSP), the O’Shaughnessy Asset Management research team grouped thousands of stocks into deciles based on dividend yield and dividend growth.
For more than 80 years (between 1930 and 2011), the top stocks by dividend yield returned 11.6 per cent annually, while the top stocks by dividend growth returned 8.1 per cent annually. During the same period, the top dividend yield outperformed all US stocks by 1.4 per cent annually, while the top dividend growers underperformed by 2.1 per cent annually.
Note this data was collected up to 2011, so does not incorporate more than a decade of stock market performance since then.
Past performance doesn’t guarantee future results.
For more than 80 years (between 1930 and 2011), the top stocks by dividend yield returned 11.6 per cent annually, while the top stocks by dividend growth returned 8.1 per cent annually. During the same period, the top dividend yield outperformed all US stocks by 1.4 per cent annually, while the top dividend growers underperformed by 2.1 per cent annually.
Note this data was collected up to 2011, so does not incorporate more than a decade of stock market performance since then.
Past performance doesn’t guarantee future results.
6. The importance of the payout ratio for successful dividend investing
The payout ratio is a critical metric for assessing dividend sustainability. It represents the proportion of earnings a company distributes as dividends. A reasonable payout ratio indicates that a company can afford to pay dividends without jeopardising its financial stability and growth prospects.
7. Conduct fundamental analysis of dividend stocks
Thorough fundamental analysis is essential before investing in any stock, including dividend stocks. Evaluate the company's financial health, competitive advantage, industry trends, and growth prospects. A deep understanding of these factors will enable you to make informed investment decisions.
8. Constantly identify reliable dividend stocks
Always be on the lookout for new opportunities - this applies to all walks of life, not least dividend investing. If any of the stocks in your portfolio start to underperform, you should always have some alternatives to replace them with that you’ve kept your eye on.
Stay informed about market trends and company performance, and be prepared to adjust your portfolio as needed to keep up the performance and levels of diversification.
Stay informed about market trends and company performance, and be prepared to adjust your portfolio as needed to keep up the performance and levels of diversification.
9. Assessing dividend sustainability
Dividend investing is a long term endeavour - so the firms that you invest in need to offer dividends that sustain over the long term too. Consider cash flow, debt levels, and management’s experience navigating financial challenges.
The following checklist, or your own version of it, can help make sure you choose the kind of companies that are capable of paying stable dividends and avoiding the ones that don’t.
The following checklist, or your own version of it, can help make sure you choose the kind of companies that are capable of paying stable dividends and avoiding the ones that don’t.
Dividend investing checklist
☑️ Does the company have a moat? |
☑️ Is the company in a growing industry? |
☑️ Is it stable or increasing revenues? |
☑️ Does it have a positive working capital during the past 3 years? |
☑️ Does it have a debt/equity close to or under 1? |
☑️ Does it have positive cash flow from operations? |
☑️ Are the dividends covered through free cash flow? |
Step number 1 in successful dividend investing is isolating a group of companies with strong competitive advantages or "moats" that make it difficult for competitors to replicate their success. This will normally be a unique product, strong brand or some new/superior technology.
Investing in companies within growing industries can benefit dividend investors, as it presents the potential for sustained growth and increasing dividend payouts over time. Assessing a company's industry and its future prospects is essential for long-term success.
You should look for companies with stable or increasing revenues, ensuring a foundation for consistent dividend payments. While some flexibility may be allowed for value investing, sustained revenue growth generally indicates a healthy and reliable dividend-paying company.
Positive working capital signifies a liquid and well-prepared company that can handle financial challenges. Dividend investors prefer companies with adequate cash reserves to support dividend payments during difficult times.
You should be cautious of over-leveraged companies, making companies with a debt/equity ratio close to or under 1x more appealing. A lower ratio reduces the financial risk and enhances the company's ability to maintain dividend payments.
Ultimately, a company needs cash to pay a cash dividend so analysing a company's cash flow statement is critical to test its ability to generate enough cash to and maintain dividend payments.
You must ensure that dividend payments are covered by free cash flow (CFFO minus capital expenditures). A company's ability to sustain dividends without relying on debt or equity financing is essential for long-term dividend growth and stability.
Investing in companies within growing industries can benefit dividend investors, as it presents the potential for sustained growth and increasing dividend payouts over time. Assessing a company's industry and its future prospects is essential for long-term success.
You should look for companies with stable or increasing revenues, ensuring a foundation for consistent dividend payments. While some flexibility may be allowed for value investing, sustained revenue growth generally indicates a healthy and reliable dividend-paying company.
Positive working capital signifies a liquid and well-prepared company that can handle financial challenges. Dividend investors prefer companies with adequate cash reserves to support dividend payments during difficult times.
You should be cautious of over-leveraged companies, making companies with a debt/equity ratio close to or under 1x more appealing. A lower ratio reduces the financial risk and enhances the company's ability to maintain dividend payments.
Ultimately, a company needs cash to pay a cash dividend so analysing a company's cash flow statement is critical to test its ability to generate enough cash to and maintain dividend payments.
You must ensure that dividend payments are covered by free cash flow (CFFO minus capital expenditures). A company's ability to sustain dividends without relying on debt or equity financing is essential for long-term dividend growth and stability.
10. Dividend reinvestment and compounding
You’re really not getting the most out of dividends if you’re not reinvesting them. It’s different once retired and looking to actively use the income - but before then, your main goal should be to grow your nest egg. Reinvesting means using the dividend to buy more shares and increase your ownership and the size of future dividend payments. The effect of compounding can really accelerate the accumulation of wealth, especially over longer time horizons.
This hypothetical example assumes an initial investment of £10,000 in 2019. Each year, the portfolio receives dividends, which are then reinvested to purchase more shares of the underlying stocks. As a result, the total portfolio value steadily increases over time.
This hypothetical example assumes an initial investment of £10,000 in 2019. Each year, the portfolio receives dividends, which are then reinvested to purchase more shares of the underlying stocks. As a result, the total portfolio value steadily increases over time.
Year | Investment value | Dividends received | Reinvested dividends | Total portfolio value |
2019 | £10,000 | £400 | £400 | £10,800 |
2020 | £10,800 | £500 | £500 | £11,800 |
2021 | £11,800 | £600 | £600 | £13,000 |
2022 | £13,000 | £700 | £700 | £14,400 |
2023 | £14,400 | £800 | £800 | £16,000 |
Please note that actual investment outcomes may vary based on market performance and dividend yields.
11. Diversification of your dividend portfolio and risk management
Diversify your dividend portfolio across different sectors and industries to mitigate risks associated with specific economic conditions. A well-diversified portfolio provides stability and minimises the impact of individual stock fluctuations.
In this hypothetical dividend portfolio, we have selected companies based on their dividend yield, growth rate, and the years they have been raising dividends. The goal is to strike a balance between higher yields and the sustainability of dividend payments.
In this hypothetical dividend portfolio, we have selected companies based on their dividend yield, growth rate, and the years they have been raising dividends. The goal is to strike a balance between higher yields and the sustainability of dividend payments.
Company | Sector | Dividend yield | Dividend growth rate | Payout ratio | Years of raising dividend |
A | Technology | 3.2% | 12% | 35% | 5 |
B | Finance | 5% | 8% | 55% | 10 |
C | Consumer goods | 2.8% | 15% | 25% | 3 |
D | Healthcare | 4.5% | 10% | 40% | 6 |
E | Utilities | 6.2% | 6% | 60% | 2 |
Past performance doesn’t guarantee future results.
In this portfolio, Company E offers the highest dividend yield of 6.2%, but it has a relatively higher payout ratio of 60%. On the other hand, Company C provides a lower yield of 2.8%, but it has a lower payout ratio of 25% and a remarkable dividend growth rate of 15%. Company B, with a dividend yield of 5.0% and 10 years of raising dividends, offers a balance between yield and dividend growth.
In this portfolio, Company E offers the highest dividend yield of 6.2%, but it has a relatively higher payout ratio of 60%. On the other hand, Company C provides a lower yield of 2.8%, but it has a lower payout ratio of 25% and a remarkable dividend growth rate of 15%. Company B, with a dividend yield of 5.0% and 10 years of raising dividends, offers a balance between yield and dividend growth.
12. Tax considerations
Understand the tax implications of your dividend investments. Different tax treatments apply to various dividend types, and tax-efficient strategies can optimise your overall investment returns. Try reading our article on UK dividend tax to learn more.
Tax treatment depends on your individual circumstances and may be subject to change.
Tax treatment depends on your individual circumstances and may be subject to change.
Recap: Summarising successful dividend investing
By incorporating these rules into your dividend investing strategy, you can enhance your chances of building a successful and resilient dividend portfolio.
Careful selection of stable companies, clear investment goals, and attention to dividend growth will lead to long-term financial prosperity. Additionally, conducting fundamental analysis, identifying reliable dividend stocks, and ensuring dividend sustainability are crucial steps in achieving consistent income and portfolio growth.
Careful selection of stable companies, clear investment goals, and attention to dividend growth will lead to long-term financial prosperity. Additionally, conducting fundamental analysis, identifying reliable dividend stocks, and ensuring dividend sustainability are crucial steps in achieving consistent income and portfolio growth.
Q: What is dividend investing, and how does it differ from other investment strategies?
It is to focus your attention on stocks of companies that regularly distribute a portion of their profits to shareholders as dividends. Unlike growth-focused strategies, dividend investing prioritises generating a steady income stream rather than solely relying on the share price to rise (capital appreciation).
Q: How can I set clear investment goals for dividend investing?
Start by defining your financial objectives and risk tolerance levels, then identify a target dividend yield and consider reinvestment options to align your portfolio with your long-term financial aspirations.
Q: What factors should I consider when analysing dividend stocks?
Your first port of call is to look at the company's dividend history, dividend payout ratio, revenue stability, cash flow. From there, you can dig in to judge its overall financial health and gauge its ability to sustain and grow dividend payments.
Q: How can I assess the sustainability of dividends from a company?
It’s all in the paperwork - examine the company's financial statements, cash flow, and profitability to ensure it has sufficient resources to cover dividend payments consistently. A healthy free cash flow and manageable debt levels are positive indicators.
Q: What are the tax considerations for dividend investing in the UK?
In the UK, dividends are subject to specific tax rates based on your income tax band. Understanding the tax implications will help you optimise your dividend investing strategy and minimise tax liabilities.
Tax treatment depends on your individual circumstances and may be subject to change.
Tax treatment depends on your individual circumstances and may be subject to change.
