Dividend-paying stocks can be a great choice for the right investor. Receiving that quarterly dividend check is satisfying. However, dividend-paying stocks aren’t always the best option. There are several circumstances in which investing in stocks that pay a dividend is a mistake. You may be one of the investors that shouldn’t be looking at dividend-paying stocks now.
What is a Dividend?
A dividend is a payment from a company to a shareholder. Profits can be re-invested in the business for future growth or paid to shareholders in the form of dividends. Companies that pay dividends usually do some of both.
There are two forms of dividends: Cash and Stocks. Most investors are familiar with cash dividends. Some companies prefer to issue additional shares of stock instead of writing of a check.
A company can also utilize a dividend reinvestment plan. The dividends are used to purchase additional shares of stock.
Investing in stocks that pay dividends can be a powerful strategy, especially if you’re investing for the distant future. But dividend-paying stocks aren’t always the best choice.
When Are Dividend-Paying Stocks a Mistake?
There are times to reconsider the purchase of dividend-paying stocks:
The company is struggling. The dividend yield of a particular company can be very attractive if the price of the stock drops significantly. However, consider why the price has dropped.
- If the stock is a great deal, then go ahead and buy it. If the price has dropped because the company is struggling, beware. The dividend is likely to decrease in the future anyway.
When the stock price is too high to justify the dividend payment. A $0.20 quarterly dividend on a $9 stock is a good deal. The same dividend on a $200 stock is not. Look at how much that dividend is going to cost you.
- When comparing different companies, look at the dividend yield. The yield is the annual dividend divided by the stock price.
It’s the wrong type of company. The best dividend paying companies are mature and lack room to grow. Paying a dividend to investors might be the best way for this type of company to spend its excess profits. However, be cautious of a young company in a growing field that’s offering a dividend. That money could be better spent on growth.
- If a growth company is paying a dividend, find out why. The management team might be making poor decisions.
The company is out of cash. Companies that are running out of money have two choices when it comes to paying dividends: Cut the dividend or borrow money to make the dividend payments. Both actions are likely to hurt the stock price.
- Stock prices respond quickly to changes in dividend payouts. Be especially careful if the company is running low on cash.
The company’s record of paying a dividend is spotty. Some companies pay their dividends as reliably as the sun rises each morning. Other companies are less reliable. Examine the dividend record of the company in question. In an ideal world, the dividend payments have been increasing regularly.
- How well has the company met its earnings projections in the past? A company that consistently falls short of expectations is a risky bet.
Interest rates are too high. When interest rates are high, banks can pay better rates than dividend-paying stocks. Keep an eye on how much banks are paying before you purchase any stock shares. Your cash might do better in the bank. Dividend-paying stocks are especially attractive when interest rates are low.
When growth is more important to you than income. Dividends are great when reliable income is important to you. However, if you’re a 24-year old investor with your eye on retirement at age 60, growth is likely to be more relevant. Consider your goals before purchasing a stock that pays dividends.
When the tax status of your account makes dividends less attractive. Dividends are taxed at the same rate as capital gains, which is lower than the ordinary income tax rate for most investors.
- A traditional IRA account requires that normal income tax rates be paid on withdrawals. This is the worst case.
- Withdrawals from a Roth IRA are not taxed, provided the requirements are met. This is the best case.
- A typical brokerage account will result in capital gains taxes on your profits. This option is the middle ground for most investors.
- Ensure that you’re considering the tax ramifications before you invest.
Investing in stocks that pay dividends is about more than just looking at the yield and creating a buy order. And dividend-paying stocks aren’t always the best choice for all investors. Consider the strength of the company, your tax situation, company history, and your investment strategy.
Just because a particular company pays a dividend doesn’t mean it’s a good investment. Perform the same basic research you would on any other stock.
Additional Tips for Investing in Stocks That Pay Dividends
Look at more than just the yield when purchasing stocks that pay a dividend. The dividend yield is the dividend divided by the stock price. This allows for easy comparison between stocks of different prices.
- However, the yield is only part of the picture. Consider the underlying financial health of the company. Some stocks have a great yield because the stock price is crashing and the company hasn’t lowered the dividend payment yet.
Avoid purchasing a stock just to collect the dividend. It’s common for investors to attempt to purchase stock before the dividend is paid and then immediately dump the stock after receiving the dividend payment. However, the stock price reflects the dividend payment. Study a few stocks that pay dividends. Look at the drop in price after the dividend is paid.
- You’ll find that the stock price falls by an amount very close to the value of the dividend payment.
- Remember that stock prices include all available public information. The dividend payout and date are both readily available to the general public.
Investors love receiving dividend payments. Something is satisfying about getting paid versus holding a stock for 10+ years without putting any money into your pocket. For certain situations, focusing on stocks that pay a dividend can be an excellent strategy. However, there are many times that dividend-paying stocks don’t make a lot of sense.