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What Are Dividends And How Do They Work?

What Are Dividends And How Do They Work?
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If you invest in stocks — or you’ve ever researched how to — you’ve probably come across “dividend.” The phrase “it pays dividends” is even commonplace in everyday speech. But what does this term mean, and precisely what are dividends?

Don’t stay in the dark any longer! I’ll break down exactly what are dividends, how they work. I’ll also tell you how to get them, and whether they’re a good idea for your journey to financial independence. 

What Are Dividends?

dividend is a way for companies to share profits by sending payments to the stock owner at regular intervals.

The board of directors of the business will decide the dividend policy and dividend per share amount. If the company’s earnings are strong, investors will anticipate a future dividend payout.

Mutual funds, stocks and even some cryptocurrencies will pay dividends as a way for the business to incentive ownership. However before you get too excited, bear in mind that not every publicly traded company will issue a stock dividend.

There are lots of “ifs” and “buts” when you ask what are dividends, so let’s dive a little deeper.

How Do Dividends Work?

On the surface level, the way dividends work is pretty simple.

Companies pay out a dividend based on how large a portion of the firm its shareholders own. 

The dividend is a sum of money paid per share. While a company might pay a large dividend, it does not necessarily mean the stock is more attractive to investors.

What matters is the dividend yield which is based on the stock price but more on that in a moment.

The company’s board of directors will pay dividends at regular intervals throughout the year. Generally, companies pay dividends every quarter.

However, in some instances, the company might pay a dividend once a year or even once a month. The firm could pay $1 over the year to anyone who owns one share (for instance, $1 in one lump sum or $0.25 per quarter). 

Of course, some investors will purchase fractional shares. So, if you own 0.2 of a stock, you’ll only receive 20% of the total dividend payment (i.e., you’d receive $0.2 over the year if you own one share that pays $1 per share annually).

Is this all making sense? Sorry, but I’m about to complicate things a little further. 

What’s the Ex-Dividend Date?

Thinking this is a system you could easily abuse by buying and selling your dividend stocks at the right time? There’s a catch. Buying a dividend-paying stock the day before a dividend is due, doesn’t necessarily mean you will receive the payment. 

Eligibility for a dividend depends on the ex-dividend date also known as the ex-date. This is the date by which a company decides that investors must own the stock to receive the dividend. Interestingly, if you sell the dividend after the ex-dividend date you’ll still receive the money.

Also, a company could decide to cut its dividend payments — or stop paying a dividend altogether — at any point. 

In 2008, General Motor ex-employees learned this the hard way. The company cut its dividend payments during the recession, meaning ex-workers could no longer live off the money.

Types of Dividends

It’s important to be clear about what are dividends since there are a few different types.

In most cases, a dividend refers to a cash dividend. These work exactly like the example I outlined above. A company pays its shareholders cash dividends by depositing money into their brokerage account. After this, you can either withdraw or reinvest the funds.

But not all companies pay stockholders dividend payments in cash. There are also stock dividends, which give their dividend-holders more company stocks.

Other dividend plans give shareholders the option of either buying more stocks or receiving cash. Often this with a discount on buying further dividend stocks to nudge them in this direction. This is known as a dividend reinvestment program. Are you familiar with the magic of compounding? A dividend reinvestment strategy is an extremely effective way of growing your wealth, leveraging your initial investment.

Finally, there are special dividends. Think of these as a one time bonus payment to shareholders. Companies might opt for this if they have a good run and decide to distribute their profits to shareholders.

Examples of Dividends

Although any publicly-traded company can pay dividends, firms that actually do this tend to be established, stable names.

Startups or high-growth companies still hitting their peak such as a business in the 5G market usually prefer to reinvest their money instead of giving it out to shareholders.

Here are some well-known companies that pay both cash dividends and stock dividends.

  • Apple
  • Disney
  • Exxon
  • Target

In the case of Apple, the firm announced in February 2021 that it intends to increase its dividend. The company paid $0.205 per share in the last two-quarters of 2020, more than $14 billion over the whole year. Now it intends to pay even more due to Apple’s success in the challenging conditions of the pandemic.

what are dividends

Source: https://investor.apple.com/dividend-history/default.aspx 

Another hugely successful company, Microsoft, is an excellent example of how dividends work as a company progresses. At the early points of its business, Microsoft didn’t bother with dividends — but as its growth became more stagnant, it began to offer them.

Microsoft introduced its dividends to keep investors interested even though the growth rate was slowing. The company continues to offer shares now.

what are dividends

Source: https://www.microsoft.com/en-us/Investor/dividends-and-stock-history.aspx 

How Do You Get Dividends?

Getting dividends is precisely the same as getting regular stocks — you have to select the stocks that actually pay dividends. 

You might also want to opt for dividend mutual funds or a dividend ETF. These options contain a bundle of dividend-paying stocks while keeping you diversified.

Figuring out which stocks pay dividends is generally pretty straightforward. Most brokerages and stock-trading apps have plenty of market data available. Usually, there’s a way to filter by the stocks that have a dividend option available. 

Alternatively, head to a financial news site with a breakdown of the best companies currently offering dividends on their stocks. CNBC and Morningstar are perfect examples.

A more tricky consideration isn’t how to buy dividend stocks but figuring out which stocks are worth buying in the first place.

How to Choose Between Dividend-Paying Stocks

Just because a stock promises to pay dividends, it doesn’t automatically make it a good option for your portfolio. A company should also be an attracktive long-term investment. 

Here are some metrics you might want to consider:

  • Dividend yield
  • Payout dates
  • Past performance 
  • Company profile and fundamentals (e.g., cash flow

Are Dividends Good or Bad?

It’s tough to make a definitive judgment over whether dividends are good or bad. It depends on what perspective you look at the issue through and what your priorities are. 

Disadvantages of Dividends

Some investors strategy is to focus on only dividend stocks and to anticipate changes to a company’s dividend policy. The primary metric they will look is the dividend yield.

You might think that such dividend income investors have an easy life waiting for the next dividend payment. However, when you look at the wider picture of what’s going on, you might reconsider.

One major disadvantage is that dividends are taxed twice. First, the company has to pay corporation tax. Then, when the investor receives the dividend money, they also have to pay tax. Of course, if they use a tax-efficient account like an IRA or 401k the tax liability can be reduced.

Don’t forget, an increase in the share price over the course of the investment will lead to capital gains tax. The capital gains rate paid varies by country and how the stock is held so do your research first. Understand the tax implications of what you’re doing and, as always, manage your risk.

Arguably the business would be more profitable in the long run if the business did not pay a dividend. Instead the business could just reinvest the cash themselves and increase the stock value.

Also, paying dividends every year or every quarter (or whichever other interval) puts a significant amount of pressure on firms to please their shareholders. If the value of the shares goes down, the income from dividends also goes down, and stockholders won’t be happy. 

Basically, the dividend price indicates a company’s ability to pay. This is often measured through the dividend yield — the income dividend holders receive relative to the share price.

The yield is calculated by multipling the dividend amount by the frequency of the payment during the year. This total is then divided by the current stock price and lastly multiplied by 100 to give a percentage.

High yields can signal that the company is in trouble. In the short term, negative company news can depress the stock price but not change the dividend figure.

Because the yield uses the most recent dividend for its calculation, the yield can be artificially increased by a low stock price. Negative news can force the company’s board of directors to reduce future dividends.

This could make the market lose faith in a company and take their money out, hurting cash flow. As a result, managers may artificially inflate their stock’s value in the short term. This aims to keep dividend-holders happy — sometimes at the expense of more long-term metrics.

Advantages of Dividends

The benefits of dividends are pretty clear. Stock investment typically means holding an asset over the long term until you eventually decide to sell. However, dividends allow you to establish an income stream even while continuing to hold.

This might be a small trickle of a few dollars at first, eventually though it could establish a passive income stream.

For anyone hoping to achieve financial independence, this is an attractive prospect and an essential part of retirement planning.

Dividends also increase the safety of an investment portfolio. Even if the stocks depreciate in value, they’ll continue to provide some income to cushion the blow.

Of course, if they appreciate in value, there’s the potential to earn even more. They also tend to offer a greater yield than bonds, the typical safe option.

On the company level, although some see dividends as a bad thing due to their potential to artificially inflate the stock price.

They can also help to improve a company’s reputation. When a firm shows it’s able to pay regular dividends, it proves that it has a solid cash flow. This both reassured existing stock owners and attracts new ones.

Bottom Line

Whether or not you think that dividend investing is the right strategy for you, you now have an informed picture of what are dividends and how they work.

For the average investor, regular dividends can play a role in a diversified portfolio providing a passive income stream. Assuming the company’s earnings are growing, the investor can be reasonably confident regular dividends are paid at the same times during the year.

As always, do your market research. Get as much information as possible on the business and market data and you’ll be setting yourself up for profitability.

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