The Beginner's Step-By-Step Overview of How Dividends Work

Many people have wondered what it would be like to sit at home, reading by the pool, living off of the passive income that arrives in the form of dividend checks delivered regularly through the mail. This common dream can become a reality, but you must understand what dividends are, how companies pay dividends and the different types of dividends that are available such as cash dividends, property dividends, stock dividends, and liquidating dividends before you start altering your investment strategy.

This step-by-step Dividends 101 resource will walk you through the basics, ensuring that you have a solid foundation before diving into the more practical content in the Ultimate Guide to Dividends and Dividend Investing.

By starting here, you'll learn to avoid tax traps such as buying dividend stocks between the ex-dividend date and the distribution date, which effectively forces you to pay other investors' income taxes. You'll also learn why some companies refuse to pay dividends while others pay substantially more, how to calculate dividend yield, and how to use dividend-payout ratios to estimate the maximum sustainable growth rate for a given company's dividend.

How a Company Pays Dividends and the Three Dividend Dates that Matter to You

Before a company can pay cash dividends to shareholders, it has to go through a legal checklist that includes declaring a declaration date, ex-dividend date, date of record, and distribution date. As an investor, you need to know what these represent.
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Companies that earn a profit can either pay that profit out to shareholders, reinvest it in the business through expansion, debt reduction or share repurchases, or both. When part of the profit is paid out to shareholders, the payment is known as a dividend. For many investors, "living off dividends" is the ultimate goal. (For more information about this, you can read the 10 Steps to Successful Income Investing for Beginners).

The Dividend Process

Dividends must be declared (i.e., approved) by a company’s Board of Directors each time they are paid. There are three important dates to remember regarding dividends:

  • Declaration date: The declaration date is the day the Board of Directors announces its intention to pay a dividend.
  • Date of record: This date is also known as the “ex-dividend” date. It is the day upon which the stockholders of record are entitled to the upcoming dividend payment.
  • Payment date: This is the date the dividend will actually be given to the shareholders of the company.

A vast majority of dividends are paid four times a year on a quarterly basis. This means that when an investor sees that, for example, Coca-Cola pays an $0.88-per-share dividend, he will actually receive $0.22 per share four times a year. Some companies pay dividends on an annual basis.

Cash Dividends, Property Dividends, and Special One-Time Dividends

Cash dividends literally represent money sent to you in the mail or direct deposited into your bank account. The goal of successful investing is to be able to have cash dividends pour into your life regularly so you don't need to work unless you desire.
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Cash Dividends

Regular cash dividends are those paid out of a company’s profits to the owners of the business (i.e., the shareholders). A company that has preferred stock issued must make the dividend payment on those shares before a single penny can be paid out to the common stockholders. The preferred stock dividend is usually set whereas the common stock dividend is determined at the sole discretion of the Board of Directors. For reasons discussed later, most companies are hesitant to increase or decrease the dividend on their common stock. (You can find a detailed discussion of preferred stock and its dividend provisions in The Basics of Investing in Preferred Stock.)

Property Dividends

A property dividend is when a company distributes property to shareholders instead of cash or stock. Property dividends are recorded at market value on the declaration date. Property dividends can literally take the form of railroad cars, cocoa beans, pencils, gold, silver, salad dressing or any other item with tangible value.

Special One-Time Dividends

In addition to regular dividends, there are times a company may pay a special one-time dividend. These are rare and can occur for a variety of reasons such as a major litigation win, the sale of a business, or liquidation of an investment. They can take the form of cash, stock, or property dividends. 

Stock Dividends Are Not Stock Splits

Stock dividends are issued when a firm mails additional shares of stock to the owners instead of, or in addition to, cash dividends. Although you aren't any richer with stock dividends that you were before, there are strong psychological benefits.
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Stock Dividends

A dividend paid in stock shares rather than cash is a pro-rata distribution of additional shares of a company’s stock to owners of the common stock. A company may opt for stock dividends for a number of reasons including inadequate cash on hand or a desire to lower the price of the stock on a per-share basis to prompt more trading and increase liquidity (i.e., how fast an investor can turn his holdings into cash).

Why does lowering the price of the stock increase liquidity? On the whole, people are more likely to buy and sell a $50 stock than a $5,000 stock; this usually results in a large number of shares trading hands each day.

A Practical Example of Stock Dividends:

Company ABC has 1 million shares of common stock. The company has five investors who each own 200,000 shares. The stock currently trades at $100 per share, giving the business a market capitalization of $100 million.

Management decides to issue a 20% stock dividend. It prints up an additional 200,000 shares of common stock (20% of 1 million) and sends these to the shareholders based on their current ownership. All of the investors own 200,000, or 1/5 of the company, so they each receive 40,000 of the new shares (1/5 of the 200,000 new shares issued).

Now, the company has 1.2 million shares outstanding; each investor owns 240,000 shares of common stock. The 20% dilution in the value of each share, however, results in the stock price falling to $83.33. Here’s the important part: the company (and our investors) are still in the exact same position. Instead of owning 200,000 shares at $100, they now own 240,000 shares at $83.33. The company’s market capitalization is still $100 million.

A stock split is, in essence, a very large stock dividend. In cases of stock splits, a company may double, triple or quadruple the number of shares outstanding. The value of each share is merely lowered; economic reality does not change at all. It is, therefore, completely irrational for investors to get excited over stock splits.

Corporate Dividend Policy, Dividend Payout Ratio, and Dividend Yield

The dividend payout ratio is important because its inverse, the retained earnings ratio, allows you to calculate a stock's maximum sustainable growth rate by multiplying it by the return on equity.
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Whether or not high dividends are good or bad depends upon your personality, financial circumstances, and the business itself.

In Determining Dividend Payout: When Should Companies Pay Dividends?, you learned that “a company should only pay dividends if it is unable to reinvest its cash at a higher rate than the shareholders (owners) of the business would be able to if the money was in their hands. If company ABC is earning 25% on equity with no debt, management should retain all of the earnings because the average investor probably won't find another company or investment that is yielding that kind of return.”

At the same time, an investor may require cash income for living expenses. In these cases, he is not interested in long-term appreciation of shares; he wants a check with which he can pay the bills.

Dividend Payout Ratio

The percentage of net income that is paid out in the form of a dividend is known as the dividend payout ratio. This ratio is important in projecting the growth of the company because its inverse, the retention ratio (the amount not paid out to shareholders in the form of dividends), can help project a company’s growth.

Calculating Dividend Payout Ratio

In 2003, Coca-Cola's cash flow statement showed that the company paid $2.166 billion in dividends to shareholders. The income statement for the same year showed the business had reported a net income of $4.347 billion. To calculate the dividend payout ratio, the investor would do the following:

Dividend Payout Ratio = $2,166,000,000 dividends paid / $4,347,000,000 reported net income

The answer, 49.8%, tells the investor that Coca-Cola paid out nearly fifty percent of its profit to shareholders over the course of the year.

Dividend Yield

The dividend yield tells the investor how much he is earning on common stock from the dividend alone based on the current market price. The dividend yield is calculated by dividing the actual or indicated annual dividend by the current price per share.

The Dividend Tax Debate

The IRS taxes dividends twice: Once when the company earns the money, and again when paid out to stockholders! In other countries, companies get a tax deduction to encourage managements to reward owners instead of building empires on their dime.
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Most dividends are taxed at a lower rate than normal income. So-called "qualified dividends" are taxed at the same rate as capital gains. For dividends to qualify for the lower rate, stocks generally must be held for at least 60 days.

This lower dividend tax rate is controversial and has been a consistent source of debate among lawmakers. 

(For more information, read The Investor's Guide to the Dividend Tax - What the Dividend Tax Is and the Dividend Tax Rates. You may also want to read What Is Double Taxation?)

Selecting High Dividend Stocks

Selecting high dividend paying stocks is an art and science. By putting together a portfolio of dividend stocks, you can use the regular income to spend or to grow your business.
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Selecting High Dividend Stocks

An investor desiring to put together a portfolio that generates high dividend income should place great scrutiny on a company’s dividend payment history. Only those corporations with a continuous record of steadily increasing dividends over the past twenty years or longer should be considered for inclusion.

Furthermore, the investor should be convinced the company can continue to generate the cash flow necessary to make the dividend payments.

Dividends Related to Cash Flow, Not Reported Earnings

This brings up an important point: dividends are dependent upon cash flow, not reported earnings. Almost any Board of Directors would still declare and pay a dividend if cash flow was strong but the company reported a net loss on a GAAP basis. The reason is simple: investors that prefer high dividend stocks look for stability.

A company that lowers its dividend is probably going to experience a decline in the stock price as jittery investors take their money elsewhere. Companies will not raise the dividend rate because of one successful year. Instead, they will wait until the business is capable of generating the cash to maintain the higher dividend payment forever. Likewise, they will not lower the dividend if they think the company is facing a temporary problem.

Debt Restrictions

Many companies are not able to pay dividends because bank loans, lines of credit, or other kinds of debt financing place strict limitations on the payment of common stock dividends. This type of covenant restriction is disclosed in a company’s 10K filing with the SEC.

Dividend Reinvestment Plans or DRIPs

When you use direct stock purchase plans, dividend reinvestment plans, or DRIPs, you pay little or no commission. This leaves more cash in your pocket. Wall Street doesn't advertise these programs because if you use them, it loses the fee income.
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Unless you need the money for living expenses or you are an experienced investor that regularly allocates capital, the first thing you should do when you acquire a stock that pays a dividend is to enroll it in a dividend reinvestment plan, or DRIP for short.

How Dividend Reinvestment Plans Work

When an investor enrolls in a dividend reinvestment plan, he will no longer receive dividends in the mail or directly deposited into his brokerage account. Instead, those dividends will be used to purchase additional shares of stock in the company that paid the dividend. There are several advantages to investing in DRIPs; they are:

  • Enrolling in a DRIP is easy. The paperwork (both online and in print) can normally be filled out in under one minute.
  • Dividends are automatically reinvested. Once the investor has enrolled in a DRIP, the process becomes entirely automated and requires no more attention or monitoring.
  • Many dividend reinvestment plans are often part of a direct stock purchase plan. If the investor holds at least one of his shares directly, he can have his checking or savings account automatically debited on a regular basis to purchase additional shares of stock.
  • Purchases through dividend reinvestment programs are normally subject to little or no commission.
  • Dividend reinvestment plans allow the investor to purchase fractional shares. Over the decades, this can result in significantly more wealth in the investor's hands.
  • An investor can enroll only a limited number of shares in the dividend reinvestment plan and continue to receive cash dividends on the remaining shares.

Example: Dividend Reinvestment Plans in Action

Direct stock purchase plans and DRIPs make it easy to compound your wealth because you can setup automatic investment plans that take money from your bank account to buy shares regularly. Dividends can be reinvested at little or no cost.
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Full Enrollment in a DRIP: Example

Jane Smith owns 1,000 shares of XYZ Company. The stock trades at $47 per share and the annual dividend is $1.56 per share. The quarterly dividend of 39 cents has just been paid.

Before she enrolled in XYZ’s dividend reinvestment plan, Jane would normally receive a cash deposit of $390 in her brokerage account. This quarter, however, she logs into her brokerage account and finds she now has 1,008.29 shares of XYZ. The $390 dividend that was normally paid to her was reinvested in whole and fractional shares of the company at $47 per share.

Partial Enrollment in a DRIP: Example

William Jones owns 500,000 shares of EZ Group. The stock trades at $49 and pays an indicated annual dividend of $3.20 per share ($0.80 per quarter). William would like to receive some cash for living expenses but would like to enroll some of the shares in a DRIP. He calls his broker and has 300,000 shares enrolled in EZ’s DRIP.

When the quarterly dividend is paid, William will receive cash dividends of $160,000. He will also receive 4,898 additional shares of EZ Group giving him holdings of 304,100.50 shares (300,000 shares * $0.80 dividend = $240,000 divided by $49 per share price = 4,898 new shares of EZ Group).

Dividends on Dividends

Why are dividend reinvestment plans conducive to wealth building? Notice that William now has 4,898 additional shares of EZ Group stock. When the next quarterly dividend is paid, he will receive $0.80 for each of those shares. Imagine the wealth that you can see as dividends turn into new shares, which produce dividends, and so on and so on. 

More Information: The Ultimate Guide to Dividend Investing

You're now ready to move on to the Ultimate Guide to Dividend Investing. There, you'll learn advanced dividend strategies, how to avoid dividend traps, how to use dividend yields to tell if stocks are undervalued, and much more.