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A dividend is a portion of a company’s earnings that it distributes to shareholders, typically as cash or additional shares of stock. The size of that dividend payment depends on the company’s dividend yield and how many shares an investor owns.
Not all companies pay dividends, but many investors look to buy stock in companies that pay them as a way to generate regular income, in addition to potentially seeing stock price appreciation. A dividend investing strategy is one way many investors look to make money from stocks and build wealth.
Key Points
• Dividends are payments made by companies to shareholders, either in cash, additional shares of stock, or property.
• Dividend payments are based on the company’s dividend yield and the number of shares owned by the investor.
• Dividend payments usually follow a regular quarterly schedule, though some may pay annually, semi-annually, or monthly.
• Companies are not required to pay dividends, and dividend payments are not always guaranteed.
• Dividend stocks can provide regular passive income, offer dividend reinvestment plans, and may have tax advantages.
What Is a Dividend?
A dividend payment is a portion of a company’s earnings paid out to the shareholders. For every share of stock an investor owns, they get paid an amount of the company’s profits, providing a way to generate income.
The total amount an investor receives in a dividend payment is based on the number of shares they own. For example, if a stock pays a quarterly dividend of $1 per share and the investor owns 50 shares, they would receive a dividend of $50 each quarter.
Companies can pay out dividends in cash, called a cash dividend, in additional stock, called a stock dividend, or in other asset types, which is known as a property dividend (or asset dividend).
Dividend payouts typically follow a regular, predictable schedule. Most dividend-paying companies distribute quarterly, though some pay annually, semi-annually (twice a year), or monthly.
Occasionally, companies will pay out dividends at random times, possibly due to a windfall in cash from a business unit sale. These payouts are known as special dividends or extra dividends.
A company is not required to pay out a dividend. There are no established rules for dividends; it’s entirely up to the company to decide if and when they pay them. Some companies pay dividends regularly, and others never do.
Even if companies pay dividends regularly, they are not always guaranteed. A company can skip or delay dividend payments as needed. For example, a company may withhold a dividend if they had a quarter with negative profits. Such a move can unsettle investors, often triggering a drop in share price as shareholders sell.
Types of Dividends
Cash dividends are the most common type of dividend paid to shareholders, but other types of dividends include stock dividends, property dividends, and special dividends.
• Cash dividends: The majority of dividends are cash dividends, which are cash payments made to shareholders, usually directly to their brokerage accounts. Cash dividends typically come from a company’s accumulated profits.
• Stock dividends: Stock dividends are payments made in the form of additional shares rather than cash. Shareholders typically receive additional common stock, making this a way for companies to reward investors while holding onto cash reserves. While the payout of stock dividends increases the number of shares investors own, it also dilutes the value of the shares at the time they’re issued.
• Property dividends: Some companies may choose to distribute a type of asset other than stocks or cash to shareholders, which could be, for example, a physical asset like a portion of land or shares of a subsidiary. These may be referred to as property dividends or asset dividends.
• Special dividends: Special dividends are one-time payments companies distribute to shareholders, often following events such as a quarter with high earnings or a company restructuring.
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How Are Dividends Paid Out?
There are four critical dates investors need to keep in mind to determine when dividends are paid and see if they qualify to receive a dividend payment.
• Declaration Date: The day when a company’s board of directors announces the next dividend payment. On this date, the company also informs investors of the ex-dividend date, record date, and payable date, typically through a press release.
• Ex-dividend date: Frequently falling on or one day before the record date, the ex-dividend date determines who qualifies for the upcoming dividend. Investors who already own the stock before this date receive the payment; anyone who buys a stock on or after the ex-dividend date does not.
• Date of Record: The date of record, also known as the record date, is when a company will review its books to determine who its shareholders are and who will be entitled to a dividend payment.
• Payable date: This is when the company pays the dividend to shareholders.
Example of Dividend Pay Out
Shareholders who own dividend-paying stocks would calculate their payout using a dividend payout ratio. Effectively, that’s the percentage of the company’s profits that are paid out to shareholders, which is determined by the company.
The formula is as follows:
Dividend Payout Ratio = Dividends Paid / Net Income
As an example, assume a company reported net income of $100,000 and paid out $20,000 in dividends. In this case, the dividend payout ratio would be 20%.
Monitoring this ratio is crucial for assessing dividend stability. A lower payout ratio may indicate that the company retains enough earnings to grow the business while providing sustainable income to investors. A higher payout ratio may signal a stable company that is able to share more of its earnings, or it could potentially be a sign of financial distress, where a company is paying out more than it’s able to sustain.
Shareholders, again, typically receive these dividends as a cash deposit in their brokerage account, or as additional shares that increase their total holdings.
Why Do Investors Buy Dividend Stocks?
Dividend payments and the stock’s potential price appreciation make up a stock’s total potential return, though price depreciation is also possible. Beyond being an integral part of a stock’s possible total market returns, dividend-paying stocks may present unique opportunities for investors in the following ways.
Passive Dividend Income
Many investors look to buy stock in companies that pay dividends to generate a regular passive dividend income. They may be doing this to supplement current income, such as in retirement. Investors who are following an income-producing strategy tend to favor dividend-paying stocks, government and corporate bonds, and sometimes real estate investment trusts (REITs), though REITs may entail higher risk.
Dividend Reinvestment Plans
A dividend reinvestment plan (DRIP) allows investors to reinvest the money earned from dividend payments into more shares, or fractional shares, of that stock. A DRIP allows investors to potentially benefit from compounding returns, assuming the share price rises over time. Their periodic payments can make dividend stocks a natural fit for a reinvestment plan, since each payout becomes an opportunity to automatically buy more shares.
Dividend Tax Advantages
Another reason that an investor may target dividend stocks is that they may receive favorable tax treatment depending on the investor’s financial situation, how long they’ve held the stock, and what kind of account holds the stock.
There are two types of dividends for tax purposes: ordinary and qualified. Ordinary dividends are taxable as ordinary income at your regular income tax rate. However, a dividend is eligible for the lower capital gains tax rate if it meets specific criteria to be a qualified dividend. These criteria are as follows:
• It typically must be paid by a U.S. corporation or a qualified foreign corporation.
• The dividends are not among the types the IRS explicitly excludes from qualified dividend status.
• Investors must have held the stock for more than 60 days in the 121-day period that begins 60 days before the ex-dividend date.
Understanding how dividend stocks generate income through regular payouts, and how qualified dividends are taxed at the lower capital gains rates rather than ordinary income rates, may meaningfully impact an investor’s tax bill over time.
Additionally, long-term investors often track their yield-on-cost — which measures the current dividend payout against the original purchase price of the stock instead of its current price — to see how their income grows as companies increase their dividend payouts over the years.
How to Evaluate Dividend Stocks
Evaluating dividend stocks requires research into a company’s financials, payout history, and dividend yield to determine whether the stock has the potential to generate reliable income over time. There’s analysis to be done, but investors will also want to take special care to look at prospective dividend yields and other variables related to dividends.
In all, investors would likely begin by digging through a stock’s financial reports and earnings data, and then looking at its dividend yield.
Analysis
As noted, investors may want to start their stock evaluations by looking at the data available, including balance sheets, cash flow statements, quarterly and annual earnings reports, and more. They can also crunch some numbers to get a sense of a company’s overall financial performance.
Dividend Yield
A dividend yield is a financial ratio that shows how much a company pays out in dividends relative to its share price — and it’s one of the key metrics investors use to evaluate dividend stocks as income-generating investments. The dividend yield can be a valuable indicator used to compare stocks that trade for different dollar amounts and with varying dividend payments.
Here’s how to calculate the dividend yield for a stock:
Dividend Yield = Annual Dividend Per Share ÷ Price Per Share
To use the dividend yield to compare two different stocks, consider two companies that pay a similar $4 annual dividend. A stock of Company A costs $95 per share, and a stock of Company B costs $165.
Using the formula above, we can see that Company A has a higher dividend yield than Company B. Company A has a dividend yield of 4.2% ($4 annual dividend ÷ $95 per share = 4.2%). Company B has a yield of 2.4% ($4 annual dividend ÷ $165 per share = 2.4%).
If investors are looking to invest in a company with a relatively high dividend yield, they may invest in Company A.
This formula is a useful starting point, but dividend yield alone does not tell the full story. A high yield can signal strong income potential or, in some cases, a declining share price — creating what are known as yield traps. To avoid these traps, investors must look beyond the yield and examine a company’s free cash flow, its overall stock valuation, and how the dividend contributes to the investment’s total return before making any investment decision.
Tax Implication of Dividends
Dividends generally trigger a tax liability for investors. Generally, regular dividends are taxed like ordinary income, and reinvested dividends (as in a DRIP) are taxed as if they were paid out as cash. If an investor receives stock dividends, though, that’s typically not taxable until the investor sells the holdings later on.
Under current IRS rules, qualified dividends are usually taxed at the lower long-term capital gains rates. These rates align with specific tax brackets — 0%, 15%, or 20% depending on your income — though strict eligibility requirements and individual tax situations dictate exactly what rate applies.
The specifics, however, depend on the type of dividend received, so if you hold dividend stocks across multiple accounts or tax situations, consulting a financial professional can help clarify your overall tax exposure.
Investors who do receive dividends should receive a tax form, a 1099-DIV, from the payor of the dividends if the annual payout is at least $10.
The Takeaway
Dividends are a way that companies compensate shareholders for owning the stock, usually in the form of a cash payment. Many investors look to dividend-paying stocks to take advantage of the regular income the payments provide in addition to the potential stock price appreciation over time.
Dividend-paying companies are often viewed as stable companies, while growth companies, where value largely comes from stock price appreciation, may be riskier. If your investment risk tolerance is low, investing in dividend-paying companies may be a consideration.
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FAQ
Are dividends free money?
In a way, dividends may seem or feel like free money, but in another sense, they’re more like a reward for shareholders for owning a portion of a company.
Where do my dividends go?
Depending on the type of dividend, they’re usually distributed into an investor’s brokerage account in the form of cash or additional stock. The exact treatment depends on the account type. For example, dividends in a tax-advantaged IRA may be reinvested without immediate tax consequences, while those in a taxable brokerage account may be subject to dividend taxes.
How do I know if a stock pays dividends?
Investors can look at the details of stocks through their brokerage or government regulators’ websites. The information isn’t hard to find, typically, and some brokerages allow investors to search specifically for dividend-paying stocks, too.
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