What is a Dividend?
A dividend is a disbursement made by a company to compensate its shareholders. They represent a portion of corporate profits paid out to stock owners either in cash, stock, or property.
Companies pay dividends on a per-share basis, so the amount each investor receives depends on how many shares they own.
How do Dividends Work?
- A company generates net income through its business operations and retains part of those earnings to reinvest into the business.
- The Board of Directors determines if excess profits should be distributed to shareholders in the form of a dividend. This decision considers factors like growth opportunities, available cash flow, and shareholders’ expectations.
- The Board declares the dividend by announcing the dividend amount per share, ex-dividend date, and payment date.
- On the ex-dividend date, the stock price adjusts downward by the amount of the declared dividend since the company’s value has decreased by the total dividend amount.
- Investors who own the stock before the ex-dividend date are eligible to receive the payment. This eligibility is based on the company’s record of shareholders on the record date.
- On the payment date, electronic transfers are sent to shareholders’ accounts with the dividend payment.
Most companies pay dividends on a quarterly basis, but the frequency can be adjusted to monthly, semi-annually, or annually depending on various factors.
Some companies offer investors dividend reinvestment plans (DRIPs) that allow them to automatically reinvest the dividends they receive into additional company shares.
Types of Dividends
There are several types of dividends that companies can distribute:
- Cash Dividend: These are cash payments sent to shareholders, usually via check, direct deposit, or investment account credits. This is the most common type of dividend.
- Stock Dividend: They consist of distributions of additional company stock to shareholders instead of cash. The number of shares that each investor gets depends on how many they own and the ratio of the dividend. For example, companies can declare a 4:1 stock dividend, meaning that for every share an investor owns, he receives 4 additional ones.
- Property Dividend: Assets such as securities or other property previously owned by the company that are distributed among shareholders.
- Liquidating Dividend: Payments made from the sale of assets when a company is liquidated.
- Scrip Dividend: Shares of stock or promissory notes offered in place of cash. The note can be redeemed later for cash.
Key Dividend Dates
There are four key dates in the dividend distribution process:
The dividend is announced by the company’s board of directors.
The last date investors can purchase the stock and still receive the upcoming dividend payment. The stock price decreases by the dividend amount at market open on this date.
Only the shareholders of record who are registered as such on this date are eligible to receive the dividend payment.
The date when dividend payments will be credited to shareholders’ accounts.
Why Do Companies Pay a Dividend?
There are several reasons why companies choose to pay dividends. These are the four most common ones:
- Distribute Profits: Dividends allow profitable companies to share their financial success directly with shareholders.
- Attract Investors: Dividends make stocks more appealing to income-seeking investors. Establishing a consistent dividend can boost share prices and lower the stock’s volatility.
- Reinvest Earnings: Mature companies with limited growth opportunities can distribute excess profits as dividends rather than reinvesting them.
- Maintain Reputation: Companies want to maintain a shareholder-friendly reputation, so they are hesitant to cut dividends.
Dividends are never guaranteed. The Board can reduce or eliminate dividends if financial conditions deteriorate and without prior notice.
Factors Influencing Dividend Payments
Certain company characteristics make regular dividend payments more feasible:
- Profitability: Consistent earnings and strong cash flows permit sizable dividend payments. Unprofitable startups generally do not offer dividends.
- Industry: Utility and consumer staple companies often pay stable dividends, given the relative predictability of consumer behavior and purchase frequencies.
- Company Maturity: Well-established companies frequently pay dividends rather than reinvesting all profits.
- Conservative Management: Some managers prefer to offer shareholders consistent dividends than taking high-risk growth opportunities.
Evaluating Dividend Stocks
Investors commonly examine several key metrics when analyzing dividend stocks, including:
Annual dividends per share divided by the stock price. This measures the return on investment (ROI) produced by the dividend alone at the current stock price.
The percentage of a company’s net profit that is paid out as dividends rather than retained. High ratios above 80% may be unsustainable.
It measures the company’s track record when it comes to dividend payments. Some variables that are worth considering include the number of years during which a dividend has been paid and how many times the dividend has been increased. Frequent or erratic dividend cuts are undesirable for investors.
Companies that periodically increase their dividend payment are considered stable and investment-worth entities. The lack of growth limits returns.
Comparing these factors helps investors identify attractively valued stocks that are likely to provide reliable dividend income.
All else being equal, share prices decrease by the dividend amount on the ex-dividend date. Investors can think of dividends as converting part of the stock value into cash in their brokerage account.
However, other factors also influence stock prices. Declining profits or an uncertain outlook may cause a company’s share value to decrease by more than the dividend payment. If strong earnings growth outweighs the dividend, the stock could potentially trade at a higher price despite the dividend distribution.
Taxes on Dividends
In the U.S., qualified dividends are taxed at the favorable long-term capital gains tax rate if the investor holds the stock for a minimum of 60 days. Non-qualified dividends are taxed as ordinary income.
Dividend Investing Strategies
There are several approaches investors utilize when analyzing opportunities in the stock market that offer attractive dividends.
- Buy and Hold: Investors identify stocks with attractive dividend yields and hold them for long periods – typically more than 5 years. Reinvesting these dividends can accelerate returns through compounding.
- Dividend Growth: The focus is on companies with a positive track record of consistently increasing their dividend payments over time.
- Dividend Aristocrats: Investing specifically in blue-chip stocks that compose the S&P 500 index or other stock market benchmarks. These aristocrats have typically increased their dividends annually for the last 25+ years.
- High Dividend Yield: Scouting stocks with abnormally high yields, which may signal undervaluation.
- International Dividends: Companies in markets like Europe and Emerging Markets offer diversification and, in some cases, higher yields.
Pros and Cons of Dividend Stocks
- They offer a predictable and relatively reliable income stream.
- Dividend reinvestment enables compounded capital growth.
- Mature and profitable companies offer steady and growing dividend payments.
- High-yielding dividend stocks tend to be trading at a lower price for a good reason – i.e., questionable dividend continuity, troubled business model.
- Investors have no control over the amount that will be distributed as dividends.
- Dividends can be reduced or eliminated by the Board without prior notice.
- They are commonly not a good alternative for investors focused on aggressive capital growth.
Dividend-Paying Stocks vs. Growth Stocks
Dividend stocks are a good alternative for conservative investors seeking income and stability. In contrast, growth stocks offer more upside potential but greater risk.
Below are some other key differences between these two stock categories:
Type of Companies
Mature and well-established companies
Younger companies focused on expanding their revenues and operations
Emphasis on generating income
Emphasis on capital appreciation
Lower price volatility
Higher price volatility
Determining the desired balance between dividends and growth will largely depend on each investor’s risk tolerance and financial goals, which are influenced by their age, employment situation, and other similar factors.
Dividends provide an attractive way for companies to share profits with shareholders directly. For investors, dividends offer a consistent income stream that can be reinvested for compounding gains.
By evaluating key dividend metrics and different dividend stock investing methodologies, investors can incorporate this type of stock into their portfolios as an income-generating component.