What Is a Dividend?

What is a Dividend?

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One of the clearest benefits of owning a prosperous business is that you get to enjoy your share of 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 its after-tax income to you in the form of a check or direct deposit, this is called a dividend.

The Importance of Dividends

Dividends are important because basic financial theory states that 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 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, many shareholder distributions 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.

Why So Many Investors Focus on Dividends

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 have 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 it's under or overvaluation. 
  • Dividend income is tax-advantaged. Most families can pay 0% in dividend taxes. Many families will pay 12% or less at the Federal level. The richest Americans will pay 22% 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 1800s. They have gone over 85 years without 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 countless difficulties and milestones in civilization, all because people still wanted a bite of chocolate. 
  • 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 rebuilding of your portfolio following horrific losses due to a mathematical phenomenon that has been studied at the Wharton School of Business.

Dividend Ex-Date vs. a 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 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. 

Dividend Growth Investors

A dividend growth investor focuses on buying stocks with a high growth rate in the absolute dividend per share. For example, Company A has a dividend yield of 1.4% right now. 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 has identified as having grown its dividend per share each and every year, without 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. 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, or high dividend yield investor as they are called more frequently, focus 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 cash flow. Someone who falls into this school of portfolio management would prefer a blue-chip business that pays a dividend that might grow at only a few percentage points per year. In a broad sense, this strategy is most suitable 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

Stock Dividends

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. 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. 

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 Reinvestment

When you reinvest your dividends, you take money the company sends you and put it back into buying more shares. You can have your stock brokerage firm do this for you or you can sign up for a dividend reinvestment program, or DRIP.

Dividend Reinvestment Programs (DRIPs)

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 the transfer agent and often provide heavily discounted (and in a few cases, outright free) trading and administrative costs.