What Is a Dividend?

Two executives happily reviewing company growth numbers
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DEFINITION

Dividends are distributions of profits on investments. They are paid out of corporate earnings directly to shareholders, who then have an opportunity to reinvest them. Typically, dividends are taxable to the shareholder who receives them unless they are in a tax-advantaged account such as a Roth IRA.

Definition and Example of a Dividend

A corporation relies on capital from its shareholders to achieve its goals and grow its business to profitability. Although investors realize they are taking a risk, they expect a return on their investment if the company becomes successful.

Of course, investors can profit by selling shares as they increase in value and take capital gains, but many firms further incentivize shareholders to keep their money in the company by paying them directly. These payments are called "dividends."

For example, Company XYZ earned a substantial profit over the past year. As a result, the board of directors has approved a cash dividend of $2 per share to be paid to investors each quarter for the next year.

How Dividends Work

Dividends are an important aspect of owning shares. Many investors expect regular payments as compensation for keeping their money in the company. The board of directors will need to decide how much of its money to keep in retained earnings and how much to return to shareholders.

Retained earnings are important for keeping capital in a company and re-investing profit in its future growth.

When a firm decides to begin paying dividends, it will need to determine its payment schedule and the amount it will pay per share. For instance, suppose a company's board of directors announces that it will pay quarterly dividends of $0.25 per share. An investor who owns 1,000 shares will benefit not only from any increases in share value but also from quarterly dividends of $250. That shareholder can then decide whether to cash out those dividends or reinvest them in additional shares.

Ex-Dividend Date vs. Dividend-Payable Date

When a company's board of directors declares a dividend, it will also declare an ex-dividend date and a dividend-payable date. The day before the "ex-date" is when anyone who owns shares will receive the next dividend, based on 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. 

Why So Many Investors Focus on Dividends

When deciding which common stocks to include in your investment portfolio, focusing on dividends offers several advantages. For starters, the dividend yield on a company's stock can serve as a sort of signal about an under- or over-valuation. Generations of academic research have consistently proven that the so-called "quality of earnings" for dividend-paying firms is higher than those that don't pay dividends. Over time, dividend-paying firms tend to outperform non-dividend-paying firms. 

Good companies have histories of maintaining and increasing their dividends even during times of economic challenge. Many firms in the consumer staples sector fall into this category. As stable investments, these types of companies continue to pay dividends.

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. That is why dividend stocks tend to fall less during bear markets. Dividends can also accelerate the rebuilding of your portfolio by giving you income to reinvest.

As an extra incentive, dividend income is tax-advantaged. While regular dividends are taxed as so-called ordinary income, qualified dividends are taxed at a lower rate.

Why Some Companies Don't Pay Dividends

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 dividend payouts down the road.

Starbucks plowed every penny it could into opening new locations for decades, without paying investors. Once it had reached a certain level of maturity and market saturation, with fewer location opportunities within the United States, it declared its first dividend in 2010.

When a company that doesn't pay dividends increases its shareholder equity, it is because investors anticipate that at some point, they will receive their money back—through either increases in shareholder value or future dividends. That makes the company attractive to investors and may help it to raise additional funding in the future.

Types of Dividend Investors

There are several different approaches that dividend investors can take, depending on their investing goals.

Dividend Growth Investors

A dividend growth investor focuses on buying stocks with a high growth rate in the absolute dividend per share. For example, suppose Company A has a dividend yield of 1.4% right now, and Company B has a yield of 3.6%. Since Company A is rapidly expanding, investors might reasonably expect the dividend to increase at a rapid rate. It is quite possible that in the end, a long-term owner of Company A stock with a horizon of a decade or longer could end up collecting more absolute dividends than a Company B shareholder, even though the starting yield was lower.

Dividend Yield Investors

A dividend yield investor focuses on buying stocks with the highest dividend yields that they deem to be "safe," which usually means the stocks are covered by a minimum ratio of payout-to-earnings or cash flow. This type of portfolio management would dictate blue-chip businesses that pay a dividend that might grow at only a few percentage points per year.

In a broad sense, this strategy is most suitable for an investor who needs substantial passive income toward the last few decades of life, since dividend growth stocks tend to beat high-dividend-yield stocks.

Dividend Aristocrats

A dividend aristocrat is a company that S&P Dow Jones Indices has identified as having grown its dividend per share every year, without exception, for 25 years or longer. That means even if you never bought another share, your dividends have grown along with the enterprise. Think of dividend aristocrats as investment royalty—the most established dividend-paying companies with long histories of success.

Reinvesting Dividends

When you reinvest your dividends, you take the money the company sends you and use it to buy more shares. You can have your stock brokerage firm do this for you, or you can sign up for a dividend reinvestment program (DRIP).

A DRIP is a company-sponsored plan that allows individuals and, in some cases, legal entities, such as corporations or nonprofits, to buy shares of stock directly from the company. DRIPs are administered by a transfer agent and often provide heavily discounted (and in a few cases, outright free) trading and administrative costs.

Stock Dividends

A stock dividend is different from an ordinary cash dividend; it happens when a company gives additional shares to owners based on a ratio. It is important to know that stock dividends are not a form of income in the traditional sense, but more often a psychological tool.

Benjamin Graham, the famed value investor and mentor to Warren Buffett, 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.

Dividends vs. Capital Gains

Dividends and capital gains both represent important forms of investor returns, but there are critical distinctions between them.

Dividends Capital Gains
Cash or additional stock payments derived from company profits Represent an increase in share value
Represent immediate shareholder returns Not booked until the stock is sold
Can be scheduled or paid at the discretion of the board of directors Based on the market value of a company, and not a board decision
Can be reinvested or cashed out by the shareholder  

Key Takeaways

  • Dividends are a form of investment return paid directly to shareholders out of company profits.
  • A firm's board of directors can choose to pay a per-share dividend on a regular schedule or any time it chooses, or none at all.
  • Investors can cash out or reinvest their dividends.
  • Dividends differ from capital gains, which represent an increase in share value and are not realized until shares are sold.

Article Sources

  1. U.S. Securities and Exchange Commission. "Dividends."

  2. U.S. Securities and Exchange Commission. "Ex-Dividend Dates."

  3. RBC Global Asset Management. "The Power of Dividends – Offering a Winning Strategy," Page 1.

  4. IRS. "Investment and Income Expenses," Page 19.

  5. MarketWatch.com. "Starbucks Plans First Ever Cash Dividend."

  6. S&P Dow Jones Indices. "S&P 500 Dividend Aristocrats."

  7. Benjamin Graham. "The Intelligent Investor," Page 52. Harper Business. 2003.