Financial headlines are often dominated by news of the highest stock yields, but that’s far from the only thing to consider when investing in a company. One necessary aspect is to look at stocks offering dividends, which are a component of an investment portfolio that can add stability and increase passive income.

This guide clarifies what dividend-paying stocks are, how they work, and some factors to consider when selecting options for your investment portfolio.

What are dividend stocks, and how do they work?

Dividends are a portion of a company’s earnings that are distributed to shareholders based on the number of shares they own, typically on a fixed basis, such as quarterly or monthly. 

There are two main types of dividend stocks based on the form of the dividend they pay:

• Cash dividends: The most common type of dividends are distributions sent to shareholders in the form of cash, providing immediate income. 
• Stock dividends: These dividends are issued as additional shares of stock, which increases the number of shares a shareholder owns over time. 

Dividend payment process

The process of distributing dividends to shareholders involves four stages: 

1. Declaration date: The date the company’s board of directors announces the dividend. 
2. Ex-dividend date: The first day the company’s stock trades without the dividend included in its price, typically set one business days before the record date.
3. Record date: The date when the company determines which shareholders are eligible to receive the dividend. Investors must be listed as shareholders in the company’s records by the close of business on this date to receive a dividend payout.
4. Payment date: The date when the company distributes the dividend to eligible shareholders, usually occurring a few weeks after the record date. 

Worth noting:Dividend payments aren’t guaranteed. The decision to offer shares that pay dividends, the amount of the dividend, and the timing of the payments are all determined by the company’s board of directors. This body can choose to increase, decrease, suspend, or even eliminate dividend payments at any time based on the company’s financial performance and strategic needs. 

Key metrics for evaluating dividend stocks

When expanding an investment portfolio, it’s important to evaluate the stock you are considering adding to your portfolio. Here are some ratios for evaluating a stock: 

• Dividend per share: The total amount of dividends paid during the period by the number of shares outstanding. 
• Dividend yield: The return on investment from dividends alone is determined by dividing the annual dividend per share by the current stock price, expressed as a percentage.
• Payout ratio: The percentage of a company’s earnings paid out as dividends, calculated by dividing the total dividends by the net income. 
• Dividend growth rate: The annualized percentage rate at which a company’s dividend payments have increased over time. 
• Earnings per share: EPS are determined by dividing a company’s net profit by its number of outstanding shares. 
• Free cash flow: The amount of cash a company generates after accounting for all operating expenses and capital expenditures. 

Benefits of investing in dividend-paying stocks

Various benefits come with investing in dividend-paying stocks — here are some benefits to consider.

Potential for incremental income

Stocks that offer cash dividends can create a steady inflow of passive income for investors without needing to sell shares. While dividends are not guaranteed, the potential income this could provides greater financial flexibility for retirees living on fixed income or investors seeking income to reinvest.  

Reduced volatility

Dividend-paying stocks have historically been shown to be less volatile than non-dividend stocks. Investors with a lower risk tolerance or those nearing retirement 

Tax efficiency: 

Dividend payments are considered a tax-efficient source of income. That’s because payments provided by qualified dividends are taxed at significantly lower rates than income earned from other sources.

Risks and considerations when choosing dividend stocks

Investing in dividend stocks also carries potential risks that can impact earnings and financial goals. Here are a few things to consider before investing. 

High dividend yield

While stocks with a high dividend yield are attractive, at a certain point, yields that are too high can serve as a sign of distress rather than value — a good dividend yield may also mean an unstable payout structure. Companies with unsustainable yields may face financial trouble, leading to cuts or stock price drops.

Excessive trading volumes

Unusually high trading volumes can indicate volatility or speculative activity, potentially destabilizing a dividend stock’s price. This concern increases around dividend-related dates, which can create short-term price volatility.

Cuts and suspensions

Companies can reduce or eliminate dividends if earnings decline or priorities shift, such as the need to repay debt. Cuts usually signal financial weakness and often trigger sharp stock price declines. 

Inflation erosion

Real income declines if a stock’s dividend growth lags behind inflation. Companies that don’t increase dividends over time can fail to preserve purchasing power, especially during high inflation periods, which reduces the long-term value of dividend income. 

How to build a portfolio of stocks offering dividends: 4 steps

Constructing a dividend stock portfolio requires careful planning to align with financial objectives while managing risks. Here are four practical steps to build an effective portfolio. 

1. Determine goals and risk tolerance

Define your investment objectives. Are you seeking a steady income stream for retirement, supplementing current income, or chasing long-term growth with increasing dividends? What’s your timeline? Your goals will influence the types of dividend stocks you choose and your overall portfolio allocation.

Assess your risk tolerance to help determine the optimal balance between higher-yielding but potentially riskier stocks and lower-yielding but more stable ones.

2. Research and select companies

Identify financially sound companies with sustainable dividends, focusing on metrics like payout ratio, dividend growth rate, and strong free cash flow. Look for firms with competitive advantages (wide moats) and consistent dividend histories.

3. Diversify across sectors and industries

Avoid concentrating your investments in a single sector. Sectors perform differently under various economic conditions, and diversifying across popular ones like healthcare, consumer staples, utilities, financials, and industrials can mitigate overall risk. 

4. Regularly review and rebalance your portfolio

Monitor the financial health and performance of the companies in your portfolio by tracking their earnings reports, dividend announcements, and any significant news that could impact their ability to pay dividends. 

As things evolve, your portfolio allocations may change based on stock prices. Rebalancing involves selling and/or buying assets to return your portfolio to your target allocation. 

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This article is intended for informational purposes only. It is not intended to provide, and should not be interpreted as individualized investment, legal, or tax advice. The GainbridgeⓇ digital platform provides informational and educational resources intended only for self-directed purposes.

Guarantees are subject to the financial strength and claims paying ability of the issuing insurance company. Annuities are issued by Gainbridge Life Insurance Company, located in Zionsville, Indiana. Annuities are long-term investment vehicles and contain terms for keeping them in force.