Dividends are a form of profit on investments. They are paid out of company earnings directly to shareholders, who can cash them out or reinvest them. Typically, dividends are taxable to the shareholder who receives them.
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. Learn more about how they work, how they differ from capital gains, and more.
What Is a Dividend?
A company relies on capital from its shareholders to achieve its goals and grow its business to a point of profitability. Although investors realize they are taking a risk, they expect to be rewarded for their investment if the company becomes successful.
Of course, investors can profit by selling shares as they increase in value, otherwise known as capital gains. But many firms further incentivize shareholders to keep their money in the company by compensating them directly. These payments are called dividends.
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. Any firm open to shareholders 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, let's say a company's board of directors announces 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.
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.
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. 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 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 reinvest.
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.
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, 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—either by increases in shareholder value or future dividends. This makes the company attractive to investors, allowing 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, 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 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 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.
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.
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.
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.
Dividends vs. Capital Gain
Dividends and capital gains both represent important forms of investor returns, but there are critical distinctions between them.
|Cash or additional stock payments made out of company profits||Represent an increase in share value|
|Represent immediate shareholder earnings when they are rewarded||Not earned until the stock is sold|
|Can be scheduled or paid at discretion of the board of directors||Based on market value of company, not a board decision|
|Can be reinvested or cashed out by the shareholder|
- 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.
- 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.