What Is a Dividend?
Dividend Definition and Explanation for New Investors
Question: What is a Dividend?
Answer: One of the nicest benefits of owning a prosperous business is that you get to enjoy your share of any profits the firm generates. Whether it's a private family company you started from nothing or stock in a multi-national conglomerate that you hold in a brokerage or retirement account, when an enterprise decides to send some of the after-tax income it has produced to you in the form of a check or direct deposit, this is called a dividend.
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Question: Why Are Dividends Important?
Answer: Dividends are important because basic financial theory states that all firms exist solely for the purpose of paying dividends, either now or at some point in the future. (When a company that doesn't pay a dividend increases in value, it is because investors anticipate that at some point the payout will occur or they believe a third-party, in anticipation of being able to extract dividends in one form or another from the business, will acquire it. For the sake of tax efficiency and due to some irrationality in the tax code, a majority of shareholder distributions these days take the form of "back door" dividends executed as part of share repurchase programs.)
During periods of rapid growth, many firms do not pay a dividend, opting instead to retain earnings and use them for expansion. Owners allow the board of directors to enact this policy because they believe the opportunities available to the company will result in much bigger dividends payouts down the road. A classic illustration is Starbucks, the world's largest coffee chain. For decades, management plowed every penny it could into opening new locations. Once it had reached a certain level of maturity, with fewer location opportunities within the United States, it declared its first dividend.
Question: Why Do So Many Investors Focus on Dividends?
Answer: Focusing on dividends when deciding which common stocks to include in your investment portfolio offers several advantages.
- It is all but impossible to fake cash. Either a company sends you the money or it doesn't. Generations of academic research has proven time and time again that the so-called "quality of earnings" for dividend paying firms is higher than those that don't pay dividends. Over time, this means that dividend paying firms have outperformed non-dividend paying firms.
- The dividend yield on a company's stock can serve as a sort of signal as to its under or overvaluation.
- Dividend income is tax-advantaged. Most families can pay 0% in dividend taxes. Many families will pay 15% or less at the Federal level. The richest Americans will pay 23.8% at the Federal level.
- Good companies have histories of maintaining and increasing their dividend even during times of economic collapse, allowing owners to enjoy food, shelter, and clothing even in the midst of fiscal storms. Take one legendary blue chip stock, The Hershey Company, founded in the 1800's. On June 15th, 2015, it distributed its 342nd consecutive dividend payout to stockholders! That is 85 1/2 years of never missing a single dividend check. It began paying them in 1929 right before the worst economic disaster in 600 years and kept right on paying as the world fell apart. It paid dividends despite an ever-changing world around it; through half-a-dozen wars, inflation, deflation, multiple Presidential administrations, a Presidential assassination, the threat of nuclear annihilation and the Cuban missile crisis, the fall of communism, pandemics, terrorist attacks, booms, busts, bubbles, recessions, low unemployment, high unemployment, several civil rights movements, riots, protests, a moon landing, and countless other milestones in civilization all because people still wanted a bite of chocolate. Over the past decade and a half alone, the dividend rate has gone from $0.50 per share to $2.14 per share, an increase of 428%.
- During times of economic stress, the dividend might create a sort of floor underneath a stock that keeps it from falling as far as non-dividend paying companies. This is the reason dividend stocks tend to fall less during bear markets. Additionally, dividends accelerate the time period necessary to rebuild your portfolio following horrific losses due to a mathematical phenomenon that has been studied at the Wharton School of Business.
Question: What Is a Dividend Ex-Date? What Is a Dividend Payable Date?
Answer: When a company's board of directors declares a dividend, it will also declare an "ex date" and a "payable date". The ex-date is the date at which the books of the corporation will be examined and anyone who owns shares on that day will receive the dividend based upon their total holdings. If you buy the stock the day after the ex-date, you won't get the upcoming dividend payment, you'll have to wait for any future ones. The payable date is the date on which the dividend is actually sent to the owners.
That is when you will see the money show up in your brokerage account, bank account, or on which it will be mailed to you if you opt for paper checks.
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Question: What Is a Dividend Growth Investor?
Answer: A dividend growth investor is a person who focuses on buying stocks that have very high growth rate in the absolute dividend per share. For example, to go back to our earlier discussion of Starbucks, the coffee giant has a dividend yield of 1.4% right now. That is somewhat low as far as dividend yields grow (you can collect almost 3.6% on your money by purchasing shares of hamburger titan McDonald's, in contrast). However, because Starbucks is still expanding so rapidly, especially overseas, analysts expect the dividend to be increased at a rate of 17.5% per annum for the next five years.
It is likely that at the end of five years, the coffee chain will still be growing more quickly than more mature competitors. In the end, a long-term owner with a horizon of a decade or longer very well could end up collecting more absolute dividends even though the starting yield was lower than other opportunities at the time.
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Question: What is a Dividend Aristocrat?
Answer: A dividend aristocrat is a company that S&P has identified as having grown its dividend per share each and every year, without fail or exception, for 25 years or longer. That means even if you never bought another share, you've been getting bigger and bigger checks over as your enterprise sells more of whatever it is that it sells; ice cream, spices, bleach, baby powder, jet engines, carbonated beverages, or what have you. Think of it as a type of investment royalty; corporations like Sysco, McCormick, Clorox, and Johnson & Johnson.
Question: What Is a Dividend Yield Investor?
Answer: A dividend yield investor, or high dividend yield investor as they are more frequently called, is someone who focuses on buying stocks with the highest dividend yields they deem to be "safe", which usually means covered by some minimum ratio of payout-to-earnings or cashflow. Someone who falls into this school of portfolio management would prefer a business such as AT&T or Verizon, which often pays a 4% to 6% dividend that might grow at only a few percentage points per year. In a broad sense, this strategy is more rational for someone who needs a lot of passive income toward the last few decades of life as dividend growth stocks tend to beat high dividend yield stocks.
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Question: What is a Stock Dividend?
Answer: When you hear about a "stock dividend", this is different than an ordinary cash dividend. It happens when a company mails additional shares to owners based upon some ratio. Technically, a stock split is a type of stock dividend. It is important to know that stock dividends are not a form of income in the traditional sense, but more often a psychological tool. (Famed value investor and mentor to Warren Buffett, Benjamin Graham wrote almost a century ago of the advantages of a company paying a regular stock dividend, especially if it retained earnings and paid no cash dividend, to give shareholders a tangible symbol of the retained profits that were reinvested on their behalf.
Those who wanted the income could sell them, while those who wanted expansion could retain them. Few businesses have adapted his approach, though one of the more famous illustrations is Tootsie Roll Industries, which has paid a stock dividend and cash dividend each year for generations.)
Question: What Does It Mean to Reinvest Your Dividends?
Answer: When you reinvest your dividends, it means you take money the company sends you and plow it back into buying more shares for yourself. You can have your stock brokerage firm do this for you or you can sign up for a dividend reinvestment program, or DRIP.
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Question: What is a Dividend Reinvestment Program?
Answer: A DRIP is a company-sponsored plan that allows individuals and, in some cases, legal entities such as corporations or non-profits, to buy shares of stock directly from the company. DRIPs are administered by the transfer agent and often provide heavily discounted (and in a few cases, outright free) trading and administrative costs.
One real-world example: Exxon Mobil currently allows investors who sign up for the DRIP to put as little as $50 per month aside, taken as automatic monthly withdrawals from a checking or savings account, and buy shares at predetermined dates. It charges virtually nothing for these services; no commissions, no fees, no annual expenses. This benefits the company because it will let the business focus on what is right for it over decades, not just days, weeks, or even years.
Question: Where Can I Learn More About Dividends?
Answer: Some of the more popular articles I've written about dividends and dividend investing can be found in this directory page, which provides a short synopsis. Additionally, you may want to learn how a company determines its dividend payout.