How to get started at dividend investing

An income-based investing strategy involves building a portfolio that can deliver a consistent flow of income while protecting your principal from undue risk. This type of investing strategy can include a variety of investment products, including bonds, GICs, real estate and real estate investment trusts (REITs), preferred shares and dividend-paying stocks. An income investing strategy may also include mutual funds and exchange-traded funds (ETFs) that invest in these types of investment products.

Dividend investing is often part of an income-based investing strategy. Frequently used by investors who are nearing or in retirement – or anyone looking to earn an income stream from their investments – dividend investing provides a regular income.

What is a dividend?

A dividend is a distribution of a portion of a company's profits to its shareholders. When you buy a company’s stock, there are two ways to make money on your investment:

1)      If that company’s shares rise above the price you paid for them, you earn capital gains.

2)      If that company pays out a portion of its profits, you earn dividends (which you can usually choose to have paid out in cash or reinvested as additional shares with a dividend reinvestment plan, also known as a DRIP).

Which companies pay dividends on their stocks?

Some companies make regular (often quarterly) dividend payments to distribute a portion of their profits to shareholders. High-growth companies (these are usually smaller, newer companies in emerging industries) tend not to make dividend payments to investors as they perceive greater value in re-investing capital to fund accelerating growth. But well-established companies in mature sectors may choose to provide value to shareholders by paying a regular dividend.

What to look for in dividend stocks

When it comes to dividend-paying stocks, it’s recommended that you look beyond just the dividend yield. If a company is dishing out dividends of 8% but that yield is based on a significant drop in its stock price, there may be fundamental issues with the company that could lead to a dividend cut or even bankruptcy.

When looking at a dividend stock’s worth, below are the important measures to consider.

Dividend yield
This is the expected yearly dividend per share, divided by the current share price and expressed as a percentage. The dividend yield can change if there are fluctuations in the stock price or changes in the dividend amount. Some investors may, for example, look for dividend yields exceeding 3%, depending on the sector. If a company is offering dividends of 10% or even 20%, this could be an indicator that the stock price should be looked at, because there may have been a significant decline and the dividend amount has yet to be cut to normalize the yield.

Payout ratio
This is the amount of the company’s annual profit that is paid out in dividends. For long-established companies, this can be as much as 50%, with the remaining profit being reinvested into the company. Very low payout ratios could signal that the company is still growing. Very high payout ratios could suggest that the company is not investing enough in itself, which could lead to reduced dividend payouts. Generally, a payout ratio of less than 50% is considered a safe dividend payout ratio.

Dividend sustainability
This involves choosing companies that consistently pay out dividends or consistently grow their dividend. Sustainability is key when choosing dividend stocks. Picking stocks that have a long history of maintaining or increasing dividend payouts, even during a recession, can be a key strategy. If you choose a stock based purely on its dividend yield, you could find your dividends being reduced or completely removed. This could have a big impact if you rely on your investment income to pay for your day-to-day expenses.

Return on Equity (ROE)
This is a way to measure how effectively a company is managing its assets to create profits. ROE is calculated by dividing the company’s net income by its shareholders’ equity. If a company can bring high ROE with little debt, this usually means it has a solid business. A high ROE can also provide a bigger cushion so that dividends keep coming in, even during a recession.

Track record
Savvy income investors have special names for the most dependable dividend stocks. “Dividend achievers” are companies that have raised their dividends for at least 10 consecutive years, and “dividend aristocrats,” have done so for 25 years or more. You can search for funds that track these companies.

How are dividends taxed?

Like capital gains and interest, any dividends you earn within a registered account, such as a registered retirement savings plan (RRSP), tax-free savings account (TFSA) or registered retirement income fund (RRIF) are tax sheltered.

In a non-registered account, taxpayers holding Canadian dividend-paying stocks get a tax break. The dividend tax credit means that dividend income is taxed at a significantly lower rate than revenue from GICs or bonds (the actual amount varies by province) or other interest-earning investments.

However, you will pay withholding tax on dividends and interest from U.S. and foreign stocks and bonds. There is a tax treaty between the U.S. and Canada that reduces this amount if you submit form W-8BEN. (Qtrade Direct Investing accounts automatically receive this tax treaty benefit by virtue of meeting acceptable IRS identity requirements when opening the account.) You will then pay a withholding tax of 15% on dividends earned and 10% on interest. Without submitting the form or meeting ID requirements, you would be charged a withholding tax of 30% for both dividends and interest. U.S. investments in RRSPs are exempt from withholding tax.

Who could benefit from an income-based investing strategy?

Retirees and people approaching retirement are a typical demographic for an income investing strategy as they often need the investment income to replace their salaries, cover day-to-day needs and enable them to maintain their lifestyle in retirement.

Retirees are not the only people who could benefit from an income- or dividend-based investing strategy. Anyone who has received a windfall—for example from an inheritance or sale of a business—may want to use that money to boost their income this could considerably improve their standard of living while preserving their original capital.  An income investing strategy can be seen as a way to safely preserve capital while generating returns that outpace inflation.

How can I get started with dividend investing?

There are a number of ways to build a portfolio that includes dividend-paying shares. You could buy individual stocks, basing your decisions on companies with a track record of delivering higher dividend yields. You could also buy funds that provide exposure to high-quality dividend-paying stocks there are a range of mutual fund and exchange-traded fund (ETF) options.

How do I sign up for a dividend reinvestment plan (DRIP)?

If you don’t need to use your dividends as an income source, you should consider setting up a DRIP. With a dividend reinvestment plan (or DRIP), the dividends you are paid from a company are reinvested to purchase more shares, allowing you to grow your investment over time.

You can set up both Canadian and U.S. DRIPs at Qtrade free of charge. Simply log in to your account and go to Accounts > Service Centre > Dividend Reinvestment. For each of your accounts, you will see a list of DRIP-eligible securities. For any security in the list, select "Active" to enroll it in the DRIP program. Read and agree to the terms and save your changes.