What Is a Dividend?

What is a Dividend?
•••

Image Source/Getty Images

The best benefit of owning shares in a prosperous business is the possibility of enjoying a portion of the profits the organization generates. Whether it's a private family company or stock in a multinational conglomerate, when an enterprise decides to send some of its after-tax income to you, you've received a dividend.

The Importance of Dividends

Dividends are an important aspect of owning shares as an investor. 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 with either interest or payments (the dividend)—which say, "Thank you for the loan." This makes the company attractive to investors, allowing them to raise additional funding in the future.

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. Starbucks is an example of this process.

Starbucks, the world's largest coffee chain, plowed every penny it could into opening new locations, without paying investors. Once it had reached a certain level of maturity, with fewer location opportunities within the United States, it declared its first dividend.

Why So Many Investors Focus on Dividends

Focusing on dividends when deciding which common stocks to include in your investment portfolio offers several advantages. For starters, the dividend yield on a company's stock can serve as a sort of signal about an under or overvaluation. Also, 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, this means that 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 collapse. For example, many investors keep stock in affordable luxury companies, dubbed toothpaste investments, such as The Hershey Company or Colgate-Palmolive. Consumers will always want a bite of chocolate and will need to brush their teeth. 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. This is the reason dividend stocks tend to fall less during bear markets. Additionally, dividends can accelerate the rebuilding of your portfolio by giving you income to re-invest.

As an extra incentive, dividend income is tax-advantaged. While regular dividends are taxed at the same rate as federal income taxes, qualified dividends are taxed at the net capital gains rate—which can be lower.

Dividends must be paid by a U.S. corporation or qualified foreign company, meet the holding period, and not be on the list of not-qualified dividends to be qualified for the maximum rate.

Dividend Ex-Date vs. Dividend Payable Date

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 that the books of the corporation will be examined, and anyone who owns shares on that day will receive the 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. 

Dividend Growth Investors

A dividend growth investor focuses on buying stocks with a high growth rate in the absolute dividend per share. For example, let's assume 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 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.

Dividend Yield Investors

A dividend yield investor focuses on buying stocks with the highest dividend yields 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 which 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 as dividend growth stocks tend to beat high dividend yield stocks.

Stock Dividends

A stock dividend is different from an ordinary cash dividend; it happens when a company gives additional shares to owners based upon 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, 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.

Dividend Reinvestment Programs

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.

Article Sources

  1. MarketWatch.com. "Starbucks Plans First Ever Cash Dividend." Accessed Feb. 17, 2020.

  2. RBC Global Asset Management. "The Power of Dividends – Offering a Winning Strategy," Page 1. Accessed Feb. 17, 2020.

  3. IRS. "Investment and Income Expenses." Feb. 17, 2020.

  4. SEC. "Ex-Dividend Dates." Accessed Feb. 17, 2020.

  5. S&P Dow Jones Indices. "S&P 500 Dividend Aristocrats." Accessed Feb. 17, 2020.

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