A dividend is when a company periodically gives its shareholders a payment in cash, additional shares of stock, or property. The size of that dividend payment depends on the company’s dividend yield and how many shares you own.
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 stock price appreciation. A dividend investing strategy is one way many investors look to make money from stocks and build wealth.
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.
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, or additional stock, known as a stock dividend.
Generally, dividend payouts happen on a fixed schedule. Most dividend-paying companies will pay out their dividends quarterly. However, some companies pay out dividends 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. However, such a move may spook the market, resulting in a drop in share price as investors sell the struggling company.
Types of Dividends
As noted, the most common types of dividends are cash dividends and stock dividends.
Cash dividends are dividends paid out in the form of cash to shareholders. Cash dividends are the most common form of dividend. Stock dividends are, likewise, more or less what they sound like: Dividends paid out in the form of additional stock. Generally, shareholders receive additional common stock.
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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. The company will inform investors of the date of record and the payable date on the declaration date. The company will notify shareholders of upcoming dividend payments by a press release on the declaration day.
• 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.
• Ex-dividend date: The ex-dividend date, typically set one business day before the record date, is an important date for investors. Before the ex-dividend date, investors who own the stock will receive the upcoming dividend payment. However, if you were to buy a stock on or after an ex-dividend date, you are not eligible to receive the future 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%. Shareholders would either receive a cash payout in their brokerage account, or see their total share holdings increase after the payout.
Why Do Investors Buy Dividend Stocks?
As mentioned, dividend payments and stock price appreciation make up a stock’s total return. But beyond being an integral part of total stock market returns, dividend-paying stocks 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 replace a salary — e.g., in retirement — or supplement their current income. Investors who are following an income-producing strategy tend to favor dividend-paying stocks, government and corporate bonds, and real estate investment trusts (REITs).
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 can help investors take advantage of compounding returns as they benefit from a growing share price, additional shares of stock, and regular dividend payments. The periodic payments from dividend stocks can be useful when utilizing a dividend reinvestment plan.
Dividend Tax Advantages
Another reason that investors may target dividend stocks is that they may receive favorable tax treatment depending on their 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 must be paid by a U.S. corporation or a qualified foreign corporation.
• The dividends are not the type listed by the IRS under dividends that are not qualified dividends.
• You must have held the stock for more than 60 days in the 121-day period that begins 60 days before the ex-dividend date.
Investors can take advantage of the favorable tax treatments of qualified dividends when paying taxes on stocks.
How to Evaluate Dividend Stocks
Evaluating dividend stocks requires some research, like evaluating other types of stocks. 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. The dividend yield can be a valuable indicator 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.
While this formula helps compare dividend yields, there may be other factors to consider when deciding on the suitable investment. There are many reasons a company could have a high or low dividend yield, and some insight into dividend yields is necessary for further analysis.
Tax Implication of Dividends
Dividends do, generally, trigger a tax liability for investors. There may be some special considerations at play, so if you have a lot of dividends, it may be beneficial to consult with a financial professional to get a sense of your overall tax liabilities.
But in a broad sense, regular dividends are taxed like ordinary income if they’re reinvested. If an investor receives stock dividends, though, that’s typically not taxable until the investor sells the holdings later on. Further, qualified dividends are usually taxed at lower rates that apply to capital gains – but there may be some variables involved that can change that.
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.
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The Takeaway
Dividends are a way that companies compensate shareholders just 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 and the stock price appreciation in total returns.
Additionally, dividend-paying companies can be seen as stable companies, while growth companies, where value comes from stock price appreciation, may be riskier. If your investment risk tolerance is low, investing in dividend-paying companies may be worthwhile.
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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 specifics depend on the type of account that dividend-paying stocks are held in, among other things.
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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