Dividend Stocks: What They Are & How They Work
Dividend investing is a method of wealth creation that has spanned generations. For some fifty years, 84% of the S&P 500's total return can be attributed to reinvested dividends - but we'll get to that a bit later.
What Is a Dividend?
Dividends are distribution payments made by corporations, both public and private. They are one way a company returns capital to investors.
How Do Company Dividends Work?
When a company decides to pay a dividend, each share of stock that the investor owns entitles him to a set dividend payment. Depending on the type of dividend that the corporation distributes, the payment is awarded in cash, additional shares or warrants to buy stock.
No law requires firms to pay dividends. The dividend is simply a measure by which a company chooses to share profit with its shareholders. REITs, on the other hand, are required to pay dividends of a minimum 90% of their net earnings. That's what enables them to qualify as REIT securities. Technically, REITs pay distributions, which are like dividends in appearance, at least from the perspective of the recipient. But while dividends may or may not be paid in cash, distributions always are.
How Often Are Dividends Paid?
Dividends usually are distributed with stockholders on a quarterly basis but also can be awarded monthly, semi-annually or annually.
What Is an Ex-Dividend Date?
The ex-dividend date is the day a stock begins trading without the value of its subsequent dividend payment. In other words, an investor who buys the stock on its ex-dividend date or after will not be able to receive a dividend for that period. Investors who own the shares prior to the ex-dividend date qualify to receive the dividend that was declared.
Do All Stocks Pay Dividends?
Not all shareholders receive dividends equally. Owners of preferred and common stock earn varying dividends to none at all, though owners of preferred stock typically receive a guaranteed, fixed dividend.
Owners of common stock, on the other hand, enjoy voting rights, but they are not guaranteed dividend payments.
In that way, dividend-paying, preferred stocks function similarly to bonds.
5 Types of Dividends
1. Cash or Stock Dividends
Some dividends are paid in cash while others are paid with additional shares. When additional shares are awarded, it is called a stock dividend.
A key benefit of a stock dividend is that it allows the corporation to share earnings with stockholders without affecting its cash balance. At the same time, investors can grow their share of the company's stock without making any additional investment.
The stock dividend also gives investors a tax break. Like any stock share, the dividend is not taxable until an investor sells. This enables them to amass more wealth without taxation. In the case that the stock dividend has a cash-dividend option, it is then deemed taxable income.
The Stock Dividend's Dilution Effect
Another consideration, share dividends have a diluting effect on share price. For instance, say the board of a publicly traded firm approves a 5% stock dividend; that would mean investors receive an additional share of stock for every 20 shares they own. But that also means that the company's total stock increases by 5%. As a result, the value of existing shares is weakened.
Despite this so-called "dilution effect," companies carry out stock dividends with the expectation that the stock's share price will rise and make up for the difference.
Dividend Reinvestment Programs
A
dividend reinvestment plan (DRIP) allows existing shareholders the option to reinvest their cash dividends into additional or fractional shares. On the dividend payment date, investors can buy shares at a significant price discount for zero or minimal commission. Some 650 companies offer this option to investors.In the long-run, shareholders who opt-in to a DRIP benefit from the compounding effect of automatic reinvestment. As dividends are increased, investors get an increasing amount on each share they own, which then enables them to buy a larger number of shares.
2. Special Dividends
A special dividend, in essence, is like a one-time bonus. It usually is given from a company that doesn't award dividends. The special dividend also could be paid in addition to regularly scheduled dividends. Corporations typically pay special dividends after an especially profitable year. Once a company offers a special dividend it's under no commitment to continue providing that payout. In fact, Microsoft paid investors a one-time dividend of $3 per share in 2004 with a total value of $32 billion. But its normal dividend rate per quarter remained the same at 13 cents per share.
3. Preferred Dividends
A preferred dividend is a fixed dividend awarded from a preferred stock. In other words, if you are a preferred stockholder, you will receive a fixed dividend every year. As a preferred shareholder you often qualify for a higher dividend rate than common shares offer. When it comes to the size of the payment, they also receive more preference than equity shareholders.
4. Ordinary Dividends
Dividends usually fall into two categories: ordinary or qualified. Ordinary dividends are a portion of the company's earnings passed onto shareholders.
5. Qualified Dividends
By contrast, qualified dividends, are dividends that meet certain criteria to be taxed at the lower long-term capital gains tax rate. Rates on qualified dividends range from 0 to 23.8% as defined by the United States Internal Revenue Code.
Are Dividends Taxed?
Dividends are taxed based on whether they are qualified or ordinary dividends. Qualified dividends can be from U.S. or foreign companies which are listed on a major U.S. stock exchange. Qualified dividends may also be from firms which are in countries with a U.S. tax treaty or considered in U.S. possession. Qualified dividends receive preferential tax treatment which could be lower than the normal tax rate. Taxes on qualified dividends are determined by tax bracket.
For instance, if you are in the 10% or 15% bracket, you don't pay taxes on qualified dividends. If you are under the 37% bracket, you pay 15%. And if you'd usually be taxed at the 37% rate, you pay 20%.
On the other hand, ordinary dividends are dividends from companies which don't meet the above criteria. Ordinary dividends may be received from REITs, employee stock benefits or tax-exempt companies. Unlike qualified dividends, they are taxed at an investor's regular income tax bracket.
How To Calculate Dividends
Let's say a company pays a dividend of $0.10 per share, an investor with 100 shares would then receive $10 in cash. If a stockholder owned 100 shares and the company issued a 10% stock dividend, he would then earn 10 additional shares, bringing the total owned to 110 shares.
How To Evaluate a Dividend Stock
There are several factors to consider when choosing which dividend stocks to buy.
1. Debt-to-Equity Ratio
Investors are recommended to find companies with long-term profitability and an earnings growth outlook of 5-15%. Companies with high debt-to-equity ratios may be more at risk of having to cut their dividends.
2. Industry Trends
Investors must also evaluate broader industry trends to ensure their chosen company is likely to do well in the current climate.
3. Dividend Yield
The dividend yield, expressed as a percentage of a stock's current price, exhibits how much a corporation pays in dividends each year relative to its stock price. The ratio gives an investor an idea of what kind of future income a stock can provide. For instance, if a stock trades for $10 per share, and the company's annual dividend is $0.50 a share, the dividend yield is 5%.
4. Dividend Growth
Dividend growth is an important consideration beyond yield. For example, a yield that is higher than other stocks in its peer group may reflect a depressed stock price, not necessarily a reliable investment. By contrast, a company which delivers a constant dividend but whose financial performance is accelerating makes for a more exciting prospect that could increase its dividend. At the end of the day, dividend growth is a stronger indicator of company quality.
5. Earnings Per Share
Earnings per share (EPS) is a metric shareholders commonly use to gauge a company's profitability. Technically, it is a financial ratio which divides the net earnings available to shareholders by the outstanding shares over a certain time period. A single EPS value for any given company can be somewhat arbitrary, but the figure is useful when evaluating a number of companies.6. Dividend Per Share
Dividends per share defines the portion of a corporation's earnings that is distributed to shareholders. Like earnings per share, it serves as another measure of a company's profitability and can help an investor gauge whether a stock makes for an attractive investment. In fact, corporations increase their dividend per share to signal strong performance.
Pros & Cons of Reinvesting Dividends
Pros
Although cash dividends and stock dividends are usually cents on the dollar or a fraction of the value of existing shares, over time, they can generate substantial wealth for investors.
Compounding
A key reason for this is compounding. When dividends are reinvested, their value tends to grow significantly. By reinvesting dividends, the investor owns more shares. And once an investor owns more shares, the larger their future dividend payments will be. Over time, dividends paid in the early years of an investment have the largest impact on total returns.
Key Takeaway: Although dividends are usually cents on the dollar or a fraction of the value of an existing share, over time, they can generate substantial wealth for investors.
Reinvesting offers several key benefits in addition to compounding:
- Purchase discount
- Built-in saving strategy
- Simplification of the investment process
By automatically reinvesting dividends in new shares, DRIPs enable a more low-key approach to investing. And since there is no lower limit on the number of shares required to be owned by an investor, all investors are eligible for dividend reinvestment plans. However, investors don't have to invest dividends into the same company to achieve compounding. Rather, they could take the cash dividends from one company and invest them elsewhere.
Cons
The downside of a reinvestment program is that investors lack control over price and time. For less sophisticated investors who don't follow the markets constantly, this won't be a significant drawback, however for more savvy investors this is likely to be seen as a significant inconvenience.
Choosing to reinvest dividends could also make your investments more unbalanced and heavily weighted in certain areas, which could lead to less diversification in your portfolio over time. And since DRIPs require you to obtain additional shares in the company in lieu of cash, this also curbs your revenue stream, which may not be ideal for some investors.
Bottom Line
Most dividends in the United States are cash dividends. Over the years, some corporations have eliminated or suspended dividends. In March 2020 alone, when the coronavirus emerged in the United States, 90 U.S. firms ended or suspended their dividends. During the 2008 financial crisis, 120 companies cut their dividends.
Tip: More than dividend yield alone, investors should look for signs of a corporation's resilience.
This underscores the importance of discernment. Although some companies possess a high-yielding dividend, when times turn tough, they often are the first to renege on their promised dividends to investors. Therefore, more than dividend yield alone, investors should look for signs of a corporation's resilience.
That said, with inflation always a potential concern for investors, many will want to look out for opportunities in dividends. Inflation averages 3%, but stocks typically grow some 10% annually. Therefore, high-performing stocks with high-paying dividends can be a robust feature of any investor's portfolio. If you keep all the above in mind, you will be able to capitalize on the benefits offered by dividends.
This article was written by
Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
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