What is a dividend? How they work, who receives them, who pays them

  • Dividends are periodic payments made to investors who own shares in a company, fund or partnership.
  • Paying regular and increasing dividends is seen as a sign of a well-run and healthy company.
  • Large, mature companies tend to pay the biggest dividends.

Long before credit cards offered reward points, stocks offered dividends.

Dividends are a distribution of a company’s profits to shareholders – a small portion of the profits to those who have invested money in the company. Like reward points, it is a monetary thank you to customers for doing business with them.

Dividends serve mutually beneficial purposes for companies and investors, especially income-seeking investors. An indication of earnings, they reflect positively on a company and the management teams that consistently deliver them.

Regular and robust dividends earn the trust of shareholders. As long as a company’s stock maintains its dividend payout, investment dollars will continue to pour into the stock.

What is a dividend?

A dividend is a payment made to a company’s shareholders. Business and financial entities such as publicly traded companies, limited partnerships and real estate investment funds issue dividends as a means of distributing their after-tax profits to investors. Mutual funds and exchange-traded funds also pay dividends.

Determined by a company’s board of directors, dividends are calculated per share. They are typically in the form of cash and are deposited directly into an investor’s financial account.

However, companies sometimes pay dividends with new shares. And in some cases, companies offer dividend reinvestment programs (DRIPs) that allow investors to apply the dividend to purchase additional shares, often at a discount.

In the US, companies usually pay dividends every quarter. But payments can also occur monthly or semi-annually.

Stocks that pay dividends

Most companies that pay dividends are large-cap, well-established, and well-endowed companies. These mature corporations do not need to reinvest profits back into the business, as small and medium-sized businesses or startups often do.

Industry sectors that are rich in dividend-paying companies – and whose companies pay rich dividends – include:

  • Telecommunications
  • Basic energy/materials
  • Financial
  • health/pharmaceuticals
  • Utilities
  • Consumer goods

Types of dividends

While all dividends come from the same source – the company’s earnings – the nature of your payments depends on the class of stock you own.

  • common dividends are paid to owners of a company’s common stock. They can fluctuate in value every quarter (or whenever they are issued). It is in a company’s interest to keep them growing, or at least constant, but there are no guarantees.
  • Preferred dividends are paid to owners of preferred shares. These are the same fixed value; they don’t fall, but they don’t rise either. However, if a company has financial problems, preferred dividends take priority over ordinary dividends in the payout hierarchy.

Occasionally, companies issue a special dividend – an extra payment to common shareholders. Special dividends are usually issued by companies that have accumulated a lot of money over the years or have had a windfall – from spinning off a subsidiary, for example. While often much larger than the regular variety, this “extra” dividend is a one-time thing.

Important dividend dates to know

There are some important dates around dividends – especially when a shareholder qualifies for them.

  • Announcement date: The day management declares a dividend, which requires shareholder approval.
  • recording date: The deadline, set by the company, that establishes the shareholder’s eligibility for a dividend. That’s when you must be on the company’s books as a shareholder to receive the dividend.
  • ex-dividend date: The date, based on stock exchange rules, on which a shareholder must own shares in order to receive a dividend for the payment period. A business day before the registration date is usually set. Shareholders who own shares one business day before the ex date receive a dividend payment. Shareholders who buy shares on or after the ex date — no.
  • Payday: The date a company issues dividend payments and shareholders receive the money in their brokerage accounts.

How are dividends valued?

In addition to the basic dollar amount, dividends are valued in a few different ways.

dividend yield

In terms of evaluating a dividend, investors look at a stock’s dividend yield – the amount of the annual dividend divided by the stock price on a given date. Measuring dividend yield levels the playing field when comparing stocks and their dividend payouts.

For example, a stock with a share price of $10 and a quarterly payment of 10 cents per share produces a dividend of 4%. At the same time, a $100 share that pays $1 per share, also quarterly, also earns a 4% dividend.

Yield and stock prices are inversely related to each other. As dividends increase, stock prices decrease. Therefore, dividend yields increase in two ways:

  • An increase in dividend payments: A company that pays a dividend of $4 on a stock valued at $100 has a dividend yield of 4%. A 10% increase in the dividend to $4.40 changes the dividend yield to 4.4% if the stock price remains static.
  • A drop in the stock price: Say, for example, the price of a stock with a dividend of $4 drops from $100 to $90. Without a change in the dividend amount, the 4% dividend yield rises to just over 4.4%.

Dividend payment rate

In addition to looking at a stock’s dividend yield, however, experienced dividend investors look even more closely at the dividend payout ratio to get a quick assessment of its reliability.

The payout ratio measures the portion of a company’s net income that goes towards paying dividends to shareholders. The higher the payout ratio, the smaller the margin of safety. As a general rule, investors look for payout ratios that fall below 80% of a company’s net income.

Dividend-paying companies also encourage investors to seek prudent financial vehicles. While investing in stocks often triggers capital gains implications, the IRS’s accounting rules on dividend payments create a slightly gentler, smoother tax impact. Instead of paying a higher capital gain rate, ordinary income rates apply to dividend payments.

the bottom line

Dividends are profitable for investors and prestigious for companies. They are a sign that the company is doing well, so well that it can afford to share the profits with its investors. In fact, one of the hallmarks of a blue-chip stock – the elite among publicly traded companies – is that it belongs to a company with an established track record of growing dividends over decades.

Companies are not required to issue dividends, but when they do, investors expect them to continue, even in difficult economic times. They also expect periodic increases. If a company announces a drop in dividend payments in a quarter, its stock price often takes a hit. And a complete suspension of dividends typically suggests a company is in trouble — and it may be time for investors to sell.

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