What is a Dividend Stock?

A dividend stock is a simple way of describing a stock that produces a dividend. A dividend is a payment or distribution by a corporation to a shareholder. Dividends can be made in the form of cash, shares of the corporation, or shares in a subsidiary business or property. A dividend is made from after-tax revenue, and to avoid double taxation, it is treated more favourably for investors by tax authorities than investment income from fixed income instruments such as a coupon payment on a bond.

Tax Treatment of Dividends

In most jurisdictions, only a certain percentage of a dividend is taxed at the investor’s marginal tax rate. This is because the dividend suffers from double taxation, first as earnings at the corporation, and second as a dividend at the investor level. To mitigate this, investors are not taxed on the full amount of the dividend, but at the dividend allowance rate.

Why Corporations Pay Dividends

Corporations that pay dividends tend to be more mature than businesses that distribute earnings to investors. This suggests that the corporation does not have enough investment opportunities to consume the entire cash flow of the business. As the business is more mature, the company chooses to return some of the earnings to shareholders to reward them for investing in the corporation. However, this suggests that dividend-paying corporations have a lower growth profile than a company that is reinvesting all cash flow back into growing the business.

Corporations that pay dividends tend to be less risky than non-dividend paying corporations, as dividends are paid after earnings and taxes (EBITDA). Many growth-stage corporations do not have adequate funds to both grow the business and pay a dividend, so by paying a dividend, corporations can give the impression that ownership of the shares is less risky than it would be for a non-dividend paying corporation.

Dividend Reinvestment Programs (DRIP)

Some corporations allow investors to choose between receiving a cash dividend or additional stock or shares in the company (equal to the stock price divided by the dividend). This is referred to as a dividend reinvestment program, or DRIP. The benefit of participating in a DRIP is that the amount of shares owned by the shareholder would compound overtime and the investor does not suffer the risk of having to reinvest (reinvestment risk) the dividend. Because fractional shares can be issued, the entire dividend gets reinvested at each dividend payment date.

Date of Record and Ex-Dividend Date

The date at which a company issues its dividend is the payment date. However, to receive the dividend, an investor is required to be the owner of shares by the shareholders of record date (this date is a certain number of days prior to the payment date, taking into account that stock trades on most exchanges require three days to settle). The day after shareholder of record date is referred to the ex-dividend date (often two days before the date of record). If an investor were to purchase the shares on the ex-dividend date, the shareholder would not be entitled to the next dividend payment, however, all things being equal, the share price of the corporation on the ex-dividend date will decline by the amount of the dividend. This represents the fact the company has committed to pay out a portion of assets in shares or cash, reducing the value of the company.

Why Would an Investor Buy a Dividend Stock?

Lower Risk, Volatility, Reducing Unsystematic Risk

An investor would purchase a dividend stock, even though the growth in the share price is usually expected to be less than a growth stock, due to the lower volatility associated the lower risk profile. Due to lower volatility, a dividend stock should decline less when the general market declines, but also rise less when overall market increases—and this feature lowers unsystematic risk and can be an important part of diversification.

Dividend Yield

Another common reason for investing in dividend stocks is to obtain a yield on your investment. A dividend yield is calculated as the dividend paid divided by the price of the shares; many investors live on the yield of their portfolio, allowing them to not reduce the principal amount of the portfolio. As mentioned prior, this income is taxed at a lower rate than income from a bond and in a low interest rate environment dividend income has become more important to investors.

Key Risks to Dividend Stock Investing

A key risk to investing in a dividend-paying corporation is the potential for a dividend decrease or cut. When a dividend is cut or reduced, the stock price tends to decline in order to bring the yield back to where it has historically been. Without going into the intricacies of forensic accounting, some simple rules of thumb to help avoid a company who will be reducing its dividend are:

• Avoid companies that have declining earnings
• Avoid companies paying out a very high portion of its cash flow, and
• Avoid corporations with a very high yield (yield increases as stock prices decline) as this often suggests the market is expecting a cut to bring the yield back in line with the historic norms.

An investor should look into the corporate history with respect to the history of dividend increases or decreases and the trends in corporate earnings to aid in picking solid, lower risk dividend stock.

American vs. Canadian Dividend Stocks

Other than tax treatment and currency value, there is no difference between Canadian dividend stocks and those in the United States. Please consult your tax advisor for specific tax information. However, should a Canadian investor purchase an American dividend stock, the dividend received will be in USD currency, which adds an extra risk of currency fluctuation.

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