What Are Dividends?
If you want to get ahead in the stock market, you have to start paying attention to the details. It’s not quite as simple as Googling a company and throwing money into a stock because it looks promising at first glance or because someone on a social media site told you it was going to the moon. There are many metrics to know about and examine. For many investors, one of the most important things to consider is dividends — which, by the way, Google doesn’t pay.
This post explores what dividends are, how they can make you money, and what to consider when reviewing them.
How Shareholders Make Money
To begin, here is a basic overview of how shareholders make money in the stock market.
1. Capital appreciation
Capital appreciation occurs when a company’s share price rises in value. For example, if you buy a share for a certain price and the share then becomes worth more, the value of your investment increases, and you can earn capital gains when you sell.
The catch is that you have to actually sell a stock at a higher price to make money. The stock market is highly volatile. If you hold onto a stock for an extended period of time, its value could plummet. Or, it could continue to climb. That’s what makes getting into stocks tricky.
2. Dividend distributions
The other way to make money from owning shares of stock is through dividend distributions, which is a payout to shareholders that’s a slice of a company’s profit.
When a company decides to issue dividends, the organization will first declare a certain price. After that, qualified stockholders receive a percentage of that amount based on how many shares they own.
While some prefer to treat these payouts as dividend income paid out in the form of cash, others take advantage of a company’s dividend reinvestment plan, transferring the dividends into additional shares, thereby owning a bigger portion of a company.
As an investor, you have the opportunity to profit from both dividend distributions and capital appreciation at the same time. Keep in mind that dividend payments are treated as taxable income.
Why companies pay dividends
Companies are not required to pay dividends to shareholders by law, and many choose not to. According to the oversight agency FINRA, nearly 84 percent of companies in the S&P 500 index — made up of large-cap companies — pay dividends. That percentage drops as the companies get smaller.
It’s in your interest as an investor to try and determine why a company chooses to issue a dividend payment. For example, established companies may issue dividends because they have an abundance of money and can afford to make extra payments to keep shareholders happy.
At the same time, a smaller company or startup may avoid paying dividends to operate as a lean organization and put their money into growth instead of giving it to shareholders. Massive organizations, like Tesla, Amazon, and Facebook, don’t pay dividends either and instead try to lure in investors promising growth in the market price of shares.
Either way, understand that smaller organizations and startups can still be worth investing in even if they don’t issue dividends. Remember, they can potentially produce profits from capital appreciation. It all depends on the company, their industry, their product, their financial statements, and a variety of other factors.
When dividends are paid
There is no set date for receiving a dividend from a publicly-traded company. It all depends on the organization, its dividend declaration date, and its payment schedule.
Most companies in the United States issue dividends on a quarterly basis. However, some companies issue dividends on a monthly or semiannual basis.
Always check a company’s distribution schedule before you purchase any shares so that you know exactly what to expect from the investment. There is nothing worse than buying a stock that you think offers a monthly return only to get disappointed when you see they offer a dividend distribution that doesn’t align with your expectations.
Gaining Approval For a Dividend
In order for a publicly-traded organization to distribute dividends, the figure must be approved by the company’s board of directors. This approval process occurs on a recurring basis.
There are several important dates to watch during the approval process.
The announcement date is the point when a company’s management announces the proposed dividends on behalf of the organization. Once the announcement is made, the board of directors votes to determine whether they agree with the distribution amount.
All dividends are subject to expiration. The date when dividend eligibility ends is called the ex-dividend date, or the ex-date.
In order to qualify for a dividend, a shareholder must buy the stock before the ex-dividend date. The cutoff date for shareholders to receive a dividend payment is called the record date.
The date that the company issues payment for a dividend is called the payment date. This is when money officially gets transferred into shareholder accounts.
Types of Dividend Payments
Cash dividends are paid directly into brokerage accounts.
You don’t have to do anything to receive a cash payment. The payment is automatically distributed into your account for you to do as you please.
If you are running a brokerage account, you can choose to transfer your cash dividend into your checking or savings account and spend it. Just remember that you have to pay taxes on dividend payments if you’re using a brokerage account.
You can also use cash dividend payments to purchase shares of other companies.
Dividend reinvestment program (DRIP)
When an investor participates in a dividend reinvestment program or DRIP, it allows them to reinvest their funds back into the stock.
A DRIP allows investors to automatically grow the number of shares they own without having to continuously invest in it. As more dividends are paid out, the overall amount of ownership will increase in small amounts.
Some companies compensate customers by paying stock dividends, allowing them to collect shares instead of cash.
Preferred dividends are issued to shareholders in the form of preferred stock. This type of stock gives the shareholder a fixed dividend and payment priority over common stockholders.
A special dividend is a non-recurring payment issued by a company to shareholders. This may occur after an exceptionally lucrative quarter, a merger, or a round of funding.
How to Review Dividends
By now you’re probably wondering how to evaluate dividends. As it turns out, it’s not that difficult. Like with most things related to investing, it’s just a matter of knowing what to look for.
Dividend payout ratio
A dividend payout ratio is the part of a company’s net income that the organization gives to shareholders in dividends. The other part that does not go to shareholders typically either goes toward reinvesting or paying down debt.
You should also look into a company’s dividend yield when reviewing a stock chart. A dividend yield tells you how much a company pays out in dividends annually, compared to its stock price at that moment.
A yield typically lowers when a stock rises in value and rises when a stock falls in value. As such, investors should be wary of high annual dividend yields, which could signal a risky investment.
Dividends per share (DPS)
Dividends per share can indicate how much in dividends an investor may expect to receive from buying common stock.
To calculate DPS, you take all the dividends over the course of a year and combine it with the sum of all special dividends. Then, you divide this figure by the weighted average number of annual common shares outstanding to arrive at the figure.
Frequently Asked Questions
Do index funds pay dividends?
It depends on the items that an index fund has in its portfolio. If the index fund carries stocks or bonds that produce dividends, then these get passed along to investors. However, most exchange-traded funds (ETFs) automatically reinvest all dividends for investors.
How do you buy dividend stock?
You can buy dividend stock by opening an account through an online brokerage firm like Schwab or Fidelity. All you have to do is sign up for a brokerage service, select a retirement account or brokerage account, fund your account, and start investing.
Just remember to look at a company’s dividend structure before buying any shares. Keep in mind that not all organizations offer dividends — and the ones that do have different distribution schedules.
Should I reinvest dividends?
One of the hardest decisions about dividends is determining whether you should take a cash payout and treat it like ordinary income or reinvest your earnings back into the stock market.
It largely depends on your financial goals and what you are trying to accomplish with your account. For example, if you’re looking to generate quick capital, you may benefit from cashing out on regular dividends as they can lead to a regular cash flow. If you’re thinking about long-term investing, it could be a good idea to let your money grow and compound, using your dividends to acquire more shares. In turn, these new shares will earn even more dividends, which leads to more shares, and over and over again.
For the best results, spend some time thinking about what you’re trying to achieve in the stock market and plan your strategy accordingly.
Another thing to keep in mind is that you can pick and choose which stocks to reinvest in. For example, you may have some shares in a portfolio that you choose to pocket and others that you choose to reinvest.
Are dividend stocks a good investment?
A dividend is only one thing to look at when assessing a company — and oftentimes, it’s not the best indicator of a company’s performance. You need to look deeper when analyzing stocks and consider metrics like price-to-earnings ratio (P/E ratio) and price-to-book ratio (P/B ratio). It’s also a good idea to analyze a company’s chart to see their performance over time.
But don’t overlook the power of dividends. According to FINRA, between 1930 and 2012, dividends accounted for nearly 42 percent of the S&P 500’s total return.
How do I know what stocks to buy?
If you’re having trouble knowing what stocks to buy, consider working with an advisor who can recommend stocks to you on a monthly basis. Look for an advisor that offers research to back up their claims, and a demonstrated history of success in the market.
One idea is to sign up for a service like The Motley Fool’s Stock Advisor service for advice on what stocks are promising. (Note that Millennial Money is now owned by The Motley Fool, but I was a fan long before the acquisition.)
It’s also a good idea to compare multiple sources when taking advice on the stock market and form your own opinion. If you blindly follow someone’s advice, you could wind up getting misled or manipulated. Learn how to assess stocks on your own and research thoroughly before buying.
You could also try using a robo-advisor when buying stocks. In short, a robo-advisor is an automated service that learns your investment needs and makes decisions on your behalf. This is a hands-off approach to investing that can sometimes be more effective than managing your account on your own.
Do REITs pay dividends?
Real-estate investment trusts (REITs) tend to have rewarding dividend policies for investors, with many paying either monthly or quarterly dividends. In fact, REITs are required by law to pay at least 90% of their net earnings to shareholders in the form of dividends to maintain special tax treatment.
The Bottom Line
Dividends can be a great way to make money over time in the stock market. As such, it’s definitely worth looking into stocks that offer them.
Just remember to thoroughly research a company to figure out why they’re offering dividends and whether the underlying stock is worth investing in. Just because a company offers a dividend doesn’t mean you should automatically jump and invest in it.
What’s more, it’s a good idea to form a dividend strategy. Determine whether you want to accept cash payouts or reinvest your funds to grow your shares.
If you have any questions, consider talking to a financial advisor who can guide you through this process. At the end of the day, it’s better to ask questions than to make poor decisions in the stock market.
Which dividend stocks are you going to buy?