Last week, I wrote about a stock picking strategy called the Dogs of the Dow. The gist of the strategy is that you take the highest dividend yielding stocks in the Dow Jones Industrial Average and make equal investments into each. The strategy hinges entirely on the use of the dividend as a way of valuing a company. I personally don’t subscribe to the strategy but I do believe dividend investing is a very important concept, especially since dividends are taxed at a lower rate!

In keeping with that thinking, I’ve been making some small investments into companies that have decent dividend yields because I think the stock market took a dump on both the good companies and the riff raff. In my research about dividends in general, I stumbled onto what’s known as the dividend growth model, which is a way of valuing a stock based on its dividend. Like the other million ways you can evaluate the value of a stock, it’s by no means predictive but can help you make investment decisions.

Dividend Growth Model

To calculate the value of a stock based on the dividend using the dividend growth model, you’ll need three pieces of information:

1. The current dividend payout
2. The growth rate of the dividend
3. Your required rate of return

You can look up the current dividend payout and the growth rate of the dividend online. The “required rate of return” is something you decide and the impact it has will be explained momentarily. The equation for calculating the value based on those three values is:

One thing to keep in mind, your required return has to exceed the growth rate of the dividend otherwise the equation falls apart.

So, let’s look at an example: Bank of America, the biggest Dog of the Dow, and proud new owner of Merrill Lynch and Countrywide. On January 6th, when I wrote this article, Bank of America closed at $14.28 a share with a dividend yield of 8.96% ($0.32 a quarter, $1.28). Bank of America also had a five year dividend growth rate of 12.17% according to DividendInvestor.com. Armed with that information, and the assumption that my required rate of return is 20%, we can calculate:

Value = (Cur. Div. * (1 + Div. Growth)) / (Req. Return – Div. Growth)
Value = ($1.28 * (1 + 0.1217)) / (0.20 – 0.1217)
Value = ($1.28 * (1.1217)) / (0.0783)
Value = $18.38

Based on the dividend growth rate of 12.17%, the model says that BAC should be worth $18.34, a premium over its current share price.

This model is a little tricky because it makes a huge assumption, that you assume dividends grow at a constant rate forever (in perpetuity), which may or may not be the case. It’s not as crazy an assumption as some other models but you should be aware of it. There are also the typical risks associated with investing based on dividends, since they can change at any time. However, it serves as a good data point during your analysis.

This guest article is courtesy of Tyler of Dividend Money, a personal finance blog with a heavy focus towards dividend investing.

For those of you who are new to investing or are just starting out in the world of investing in stocks, there is a lower-risk strategy that has been proven to be very powerful in producing long term returns.

This strategy is known as dividend growth investing. While it is not glamorous, there have been several books written about dividend investing and many successful investors have followed this model.

Dividend investing is geared toward those of us who are not huge risk takers and have the patience to slowly watch the increases in dividends filter into our brokerage accounts.

The concept behind the dividend growth model of investing is to buy solid, reasonably priced companies with a track record of raising their dividend year after year.

This model is thought to be prudent due to the fact that the incremental increases in the dividend rate will ultimately increase one’s dividend yield as a percentage of the purchase price. It is also thought that the increases in dividend rate will support higher stock prices over the long term as income investors search for attractive yields.

This strategy is suitable for conservative investors and income investors who want to protect against inflation. It is thought that the increases in dividend rate can be viewed as a hedge against inflation because of the additional income that the dividend increases provide.

The majority of the companies that fall into this category are relatively stable and very large in nature. Many large financial, insurance, telecom, and utility companies have a reputation for increasing their dividends on at least a yearly basis.

I’ve previously written a primer on how to select the best dividend growth stocks that will be helpful if you think that dividend investing is right for you.

I think that as you investigate dividend growth investing, you will find that it has its merits and I believe you will be pleasantly surprised with the strategy.

This is the third post a series of Tax Relief advice articles, be sure to read the first one about Deducting State Sales Tax Instead of State Income Tax and the second one about the Alternative Minimum Tax. You can see the whole collection under the category of Tax Relief 101.

If you invest in anything whatsoever, capital gains and losses are a necessary and often misunderstood aspect of your taxes. What differentiates a long term capital gain and a short term capital gain? If I miss on an investment, how can that pain be lessened by gains you’ve had in other investments? What’s this I’ve heard about dividends being taxed at a lower rate? Get your pens and pencils and read on.

Long Term vs. Short Term Gains
If you’ve owned the investment for over 366 days (1 year plus 1 day), then it is taxed as a long term capital gain. If you’ve owned it for less than a year, it’s taxed as a short term capital gain. It’s as simple as that.

Recently, the long term capital gains tax rate was lowered by 5% for every tax bracket (effective until 2008) . Now, the rates are 5, 15, 25, and 28%. If your income is taxed in the 10-15%, your maximum long term capital gain tax is 5%. Everyone else is taxed at the 15%. The 25% rate applies to real estate you’ve sold that you claimed any depreciation on (Section 1250 property). The final 28% category is for small business stock and collectibles.

Short term capital gains? They’re taxed as income for the year! If you’re in the 15% tax bracket, it’ll be taxed at 15% (instead of at 5%). That’s why they say that short term capital gains can eat into your stock profits because of the significantly higher (10% difference) tax rate.

Capital Losses Offsetting Capital Gains
If you make a bad pick (or two or twenty), any losses you sustain can be used to offset any gains you had this year. If you had a particularly bad year and had no gains, up to $3,000 of the losses can be used to offset your other income. If you’ve lost more than $3,000, then you can carry it to the following year. That’s why you hear advice from professionals about selling stocks in which you’re in the red in order to offset the gains you’ve had. One important rule you must understand is the “Wash Rule” which only allows this offset if you do not repurchase the stock within 30 days, otherwise this is thrown out.

Dividends Taxed at 5, 15%
Remember the two tax brackets for gains? Well now dividends are taxed at those rates, 5% for 10-15% taxpayers and 15% for everyone else.

I hope I’ve covered a few of the big concepts of capital gains taxes that give people the most trouble and dispelled some of the misconceptions people carry around. I wouldn’t let capital gains taxes dictate your investment strategy but it’s a very important aspect to always keep in mind.