When examining the 2 ways of getting paid to invest—capital gains and dividends—it's natural that dividends have special appeal. A stock's capital-gains potential is influenced significantly by what the market does in a given year. Stocks can buck a downward market, but most don't. On the other hand, dividends are usually paid whether the broad market is up or down.
The dependability of dividends is a big reason to consider dividends when buying stock. Not every stock must pay a dividend, but a steady, dependable dividend stream provides nice ballast to a portfolio’s return. For example, Procter & Gamble, the consumer-products giant, has paid a dividend every year since 1891. Procter & Gamble's stock price has not risen every year since 1891, but shareholders who owned the stock at least got paid during those down years. They weren't totally dependent on capital gains to get paid.
Payback on your initial investment
The rising dividend stream not only provides a hedge against inflation, but also accelerates the payback on investment. Think of payback as a safety-net approach to stock investing. Nobody knows for sure how a stock is going to behave over time, but calculating a payback period helps establish an expected baseline performance—or worst-case scenario—for getting your initial investment back. Most investors look at 2 stocks and select the one they believe has the most upside over time. This places all the focus on reward. Calculating a stock's payback based on dividend flow forces you to address the following question: If this stock never makes me any money in terms of price appreciation, how long would it take for the dividend payments to bail me out of my initial investment?
To understand the concept of payback, look at the following example. Let's say you buy 200 shares of a $40 stock. Your investment is $8,000 and the stock pays an annual dividend of $1.20 per share (that's a yield of 3%). Based on that dividend, you expect to receive $240 in dividends the first year. If that dividend stream never changes, you will recoup your initial $8,000 investment in roughly 33 years. What if that dividend stream grew just 5% per year? You would recoup your initial investment in 20 years. In other words, your payback period would be reduced by some 13 years.
This calculation is not affected by the movement of the stock price over time. It isn't impacted by the stock's yield over time. It only makes one assumption—expected dividend growth—to compute the length of time to recoup your initial investment.
Should you focus on stocks that have the quickest payback? Not necessarily. Ultimately, total return is what matters. It's great to have a stock pay back your initial investment in just 15 years, but it's better to own a stock that increases your initial investment 5-fold in 15 years. Still, using dividend payback is a worthwhile concept for framing the risk-return potential of 2 stocks.
Dividend-paying stocks provide a way for investors to get paid during rocky market periods, when capital gains are hard to achieve. They provide a nice hedge against inflation, especially when they grow over time. They are tax advantaged, unlike other forms of income, such as interest on fixed-income investments. Dividend-paying stocks, on average, tend to be less volatile than non-dividend-paying stocks. And a dividend stream, especially when reinvested to take advantage of the power of compounding, can help build tremendous wealth over time.
However, dividends do have a cost. A company cannot pay out dividends to shareholders without affecting its market value.
Think of your own finances. If you constantly paid out cash to family members, your net worth would decrease. It's no different for a company. Money that a company pays out to shareholders is money that is no longer part of the asset base of the corporation. This money can no longer be used to reinvest and grow the company. That reduction in the company's "wealth" has to be reflected in a downward adjustment in the stock price.
A stock price adjusts downward when a dividend is paid. The adjustment may not be easily observed amidst the daily price fluctuations of a typical stock, but the adjustment does happen. This adjustment is much more obvious when a company pays a "special dividend" (also known as a one-time dividend). When a company pays a special dividend to its shareholders, the stock price is immediately reduced.
The ex-dividend date
This downward adjustment in the stock price takes place on the ex-dividend date. Typically, the ex-dividend date is 2 business days prior to the record date. The ex-dividend date represents the cut-off point for receiving the dividend. You have to own a stock prior to the ex-dividend date in order to receive the next dividend payment. If you buy a stock on or after the ex-dividend date, you are not entitled to the next paid dividend. If this sounds unfair, remember that the stock price adjusts downward to reflect the dividend payment.
Therefore, while you are not entitled to the dividend if you buy on or after the ex-dividend date, you are paying a lower price for the shares.
Many investors believe that if they buy on the record date, they are entitled to the dividend. However, stock trades do not "settle" on the day you buy them. You need to be a shareholder on the record date, which means you have to buy before the record date. The ex-dividend date essentially reflects the settlement period.
You may wonder if there is a way to capture only the dividend payment by purchasing the stock just prior to the ex-dividend date and selling on the ex-dividend date. The answer is "not quite."
Remember that the stock price adjusts for the dividend payment. You buy 200 shares of stock at $24 per share on February 5, one day before the ex-dividend date of February 6, and you sell the stock at the close of February 6. The stock pays a quarterly dividend of $0.50 per share. The stock price will adjust downward on February 6 to reflect the $0.50 payment. It's possible that, despite this adjustment, the stock could actually close on February 6 at a higher level. It is also possible that the stock price could close February 6 at a level lower than the $23.50 price suggested by the $0.50 adjustment to reflect the $0.50 dividend.
For the sake of this example, assume the stock adjusts perfectly and you sell at $23.50 per share. Are you better or worse off for capturing the dividend? You will receive $0.50 per share in the dividend, but you’ll lose $0.50 per share because of the decline in the stock price. It would appear to be a wash. But what about taxes? Aren’t dividends currently taxed at a maximum 15% rate? The answer is "yes," but with a catch. In order to receive the preferred 15% tax rate on dividends, you must hold the stock for a minimum number of days. That minimum period is 61 days within the 121-day period surrounding the ex-dividend date. The 121-day period begins 60 days before the ex-dividend date. When counting the number of days, the day that the stock is disposed is counted, but not the day the stock is acquired.
If the stock is not held at least 61 days in the 121-day period surrounding the ex-dividend date, the dividend does not receive the favorable 15% rate and is taxed at your ordinary tax rate.
To recap your dividend capture strategy:
You paid $4,800 (plus commission) to purchase 200 shares of stock.
Because you bought before the ex-dividend date, you're entitled to the dividend of $0.50 per share, or $100. But because you didn't hold the stock for 61 days, you'll pay taxes at your ordinary tax rate. Let's assume you are in the 28% tax bracket. That means your take after taxes is $72.
You sold 200 shares at $23.50 for $4,700, a loss of $100 (plus commissions). You now have a "realized" short-term loss, which you can offset against realized capital gains or, if you have no realized gains, up to $3,000 of ordinary income.
In this case, the dividend-capture strategy was not a winner. You're out the commissions to buy and sell the shares, you have a realized loss that you may or may not be able to write off immediately (depending on the amount of realized gains and losses you already have), and you lose the preferred 15% tax rate on your dividends because you didn't hold the stock long enough.
The bottom line
There are no free lunches on Wall Street, and that includes dividend-capture strategies. Between commissions, taxes, and downward adjustments for dividend payments, it’s not easy to profit from dividend-capture strategies. Be sure to keep this in mind the next time you consider buying and selling stocks for the sole purpose of nabbing dividend payments.
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Article partially appeared on fidelity.com
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