Dividend Stocks for Passive Income: What to Know Before Investing

Companies paying dividends distribute a portion of their earnings or capital to shareholders. These payments may provide recurring investment income, but past dividend payments do not guarantee future payments, can change, and can stop completely at any time.

This guide explains how dividends work, how dividend yield is calculated, potential risks involved, common factors Canadian investors often consider when evaluating companies, and more.

What is a dividend stock?

A dividend stock is a share of a publicly traded company that pays dividends to its shareholders. A dividend is a distribution of a portion of a company's earnings or capital to its shareholders, as declared by its board of directors. Dividends are usually paid in cash, but in some cases they may be paid as additional shares.

That said, companies are not required to maintain dividend payments. A board of directors can increase, decrease, suspend, or eliminate payments altogether, depending on the company's financial position and other factors. Because of this, dividend policies can vary significantly between companies and industries.

Can dividend stocks produce passive income?

Dividend stocks may provide recurring investment income, which is why dividend-paying companies are sometimes mentioned when discussing passive income streams. That said, referring to dividend income as passive implies that payments are more predictable than they may be. As mentioned, payments can change, and the market value of company shares can fluctuate.

There are several factors that may affect the amount actually received by investors:

• The number of shares held

• Applicable taxes

• Currency changes

• Trading and account management costs

• Changes made by the company

Ultimately, dividend stocks may provide investors with recurring investment income, but both the payment and the value of the underlying shares can change.

How dividend income is generated

Dividend income is generated based on the number of shares held and the dividend set per share.

To determine total dividend income: Dividend income = number of shares held as of the record date x dividend per share. For example, if an investor owns 200 shares, and each dividend payment is $0.50 per share, the income generated would be $100.

Companies may have different payment schedules. Common schedules include:

• Monthly

• Quarterly

• Semi-annually

• Annually

• One-time payments

Dividend payments may also be reinvested through a dividend reinvestment plan (DRIP). Rather than receiving a payment in cash, payments can be used to purchase additional shares or units. Reinvested dividends can increase exposure to the same investment. But they do not remove market risk, and future dividends are not guaranteed, simply because previous dividends were reinvested.

Common dividend terms and metrics explained

The following metrics are commonly discussed when describing dividend-paying companies. They are explained here for educational purposes only. No single metric, or combination of metrics, indicates whether a particular stock is a suitable investment:

Dividend yield

Dividend yield compares a company’s annual dividend with its current share price. For example, a stock that pays $2 per share in annual dividends with a $50 share price would have a dividend yield of 4%.

Calculation: dividend yield = annual dividend per share / current share price x 100

A dividend yield can change when the dividend or share price changes. For example, if a share price decreases while the dividend remains the same, the yield will increase. A sharp price decline can increase the yield while also reflecting other factors related to the company’s financial condition.

Dividend history

A company’s dividend history shows how it has paid its investors over time. Some companies have maintained or increased dividend payments over the years, while others have reduced or suspended payments. Past dividend payments do not guarantee future payments.

Payout ratio

Payout ratio looks at how much of a company’s earnings are distributed as dividends.

Calculation: Payout ratio = dividends / earnings x 100

Payout ratios can also be calculated relative to a company’s cash flow rather than earnings, and this can vary between companies and industries

Earnings and cash flow

Revenue and earnings reflect a company’s performance levels, while cash flow reflects how much cash is generated by the business. Free cash flow reflects the cash remaining after expenditures. Debt obligations are one factor that can affect how much capital remains available for dividends.

Debt and capital requirements

Debt payments, acquisitions, expenditures, business development, research, and other costs can affect how available funds are allocated after other obligations are paid.

Sector and business concentration

Companies that pay dividends are not equally distributed across all sectors. A dividend-focused investment portfolio can be concentrated in a particular industry, region, or currency.

Possible risks and limitations of dividend investing

While dividends can provide investors with investment income, they do come with risks:

Dividend reductions or suspensions

A company can reduce or suspend a dividend because of debt obligations, decreased earnings, changing business conditions, board member decision-making, and issues with cash flow.

Share-price risk

Obtaining dividends does not prevent the share price from falling. An investment can generate dividend income while also experiencing a decrease in market value.

Yield traps

A high dividend yield can, in some circumstances, be the result of falling share prices rather than a larger dividend payment. If a company's financial health diminishes, the dividend payment itself may be reduced in the future.

Inflation risk

Dividend income may lose purchasing power if payments do not increase at the same pace as inflation.

Concentration risk

A portfolio that is concentrated in dividend-paying companies may be oversaturated in a particular region, currency, or industry, which can be risky.

Opportunity cost

Some companies choose to retain earnings rather than pay dividends to their shareholders. Instead, the company may use that money to expand business operations and reduce debt, which can increase share price. By focusing only on dividend-paying companies, investors may exclude companies that generate other forms of returns.

Tax and currency effects

Foreign dividends can be affected by withholding taxes, while exchange rates can change the value of payments that are received in other currencies. The type of account where shares are held will also affect how investment income is treated for tax purposes.

Dividend income and Canadian account types

Tax treatment for dividend income depends on the type of dividend, the account holding the investments, and other factors:

• Tax-free savings account (TFSA): In a TFSA, investment income like dividends is generally considered tax-free, including withdrawals. However, foreign withholding tax may still apply to foreign dividends held in a TFSA, depending on the country and applicable tax treaty, and amounts withheld generally cannot be recovered.

• Registered retirement savings plan (RRSP): An RRSP provides investors with tax-deferred treatment while dividend funds remain in the plan. Contributions to the tax-advantaged account are considered deductible, while withdrawals are taxable.

Non-registered accounts

In non-registered accounts, dividend payments are considered investment income, which is taxable. CRA rules (opens in a new tab) treat eligible dividends differently from other-than-eligible dividends. The amount of tax applied and any dividend tax credits will depend on which type is received.

Furthermore, foreign dividends are treated differently from Canadian dividends in terms of taxes. The Canada-U.S. Tax Treaty (opens in a new tab) outlines rules related to holding U.S. dividends and applicable tax treatment.

Dividend income calculation example

An investor owns 300 shares of a company that has a total annual dividend of $1.50 per share.

300 shares x $1.50 = $450 in annual dividend income.

If the company pays dividends quarterly in four equal payments:

$450/4 = $112.50 per quarter in dividend income payments.

Note that $450 doesn't consider taxes, currency conversions, fees, or other economic conditions.

Dividend income and total return

Dividend income does not equate to an investor's total return. To calculate total return: investment income + change in market value = total return.

For example, a stock may pay $100 in dividends over a certain period of time, even while its market value falls by $200. The dividend would still provide income, but the overall return would be negative before any taxes and other fees are considered.

That said, the opposite of this example can occur. A company that does not pay any dividends may still produce a positive return if its share price increases.

Conclusion: Understanding the role of dividend stocks for passive income investments

Dividend-paying stocks may provide recurring income to investors. But the payment is not guaranteed, and underlying company shares remain exposed to market conditions and other risks. Depending on the type of investment account used to invest in dividend-paying stocks, tax treatment will vary.