Why Do Companies Pay Dividends?

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How Are Dividends Paid?

When it comes to choosing investments, one of the most important things to consider is your expected return. Stock investors can make money through capital gains when stock prices increase. But some can also make money from dividends, even if the stock price falls.

There are several good reasons that companies may choose to issue dividends, including rewarding current shareholders and attracting new investors. But some companies choose not to pay dividends and to instead spend their profits elsewhere.

In this article, we’ll break down what a dividend is and why some companies pay dividends while others don’t.

What Is a Dividend?

A dividend is a payment that a corporation pays to its shareholders. These payments are a portion of the company’s profits that it passes on to its investors. Dividends are usually paid in the form of cash, but companies may also pay their shareholders in the form of stock or another type of property.

Someone who owns a company’s stock is considered a “shareholder.”

Certain types of stock are more likely to result in dividend payments. For example, preferred stocks are more likely to pay dividends than common stocks; and income stocks pay dividends consistently, while growth stocks rarely do. Dividends are usually paid on a fixed schedule. Those that aren’t are referred to as “special” or “extra” dividends. 

Why Do Companies Pay Dividends?

Dividends are one of two primary ways that investors earn money through stock investing; the other being capital gains. And while dividends can be enticing to investors, not all companies pay them. Let’s discuss why companies pay dividends, as well as a couple of reasons why a company might not.

Sharing Profits With Investors

Simply put, dividends are a way for companies to share their profits with investors. Companies can use dividends to reward investors and entice them to stick around. But for a company to share profits with investors, it must actually have profits to share. As a result, dividends are most common from well-established companies that generate consistent revenue. Stocks of such companies are usually known as income stocks and pay regular dividends.

Attracting Investors

Dividends can be an excellent way of attracting investors since they know they’ll have recurring income from the stock regardless of what happens with its share price. Dividends are an especially important tool during seasons when share prices are stagnant or decreasing, as investors still have a way to make a profit. In fact, dividends can entice more investors during these seasons, causing the company’s stock price to increase.

Why Companies Don’t Pay Dividends

So, if dividends help to attract and maintain investors, why don’t all companies pay them? While there are solid reasons that companies choose to pay dividends, there are also good reasons why some don’t.

First, when companies pass their profits on to the shareholders, they aren’t reinvesting them back into the company. And ultimately, those reinvestments can help the company to grow, thereby increasing the stock price.

Dividends are less common among startups and other growing companies that must reinvest in the company to grow. These stocks, known as growth stocks, are often considered a good trade-off for investors because they expect significant capital gains.

A company may pause dividend payments—or eliminate them entirely—due to financial hardship.

In the wake of the auto industry crisis and the company’s bankruptcy, General Motors stopped making dividend payments on its common stock. It wasn’t until six years later, in 2014, that the company resumed payments. Similarly, the company announced in early 2020 that it would be pausing dividends on its common stock to help preserve cash. As of May 2021, it hasn’t resumed these dividend payments.

Types of Dividend Payments

Most companies pay dividends in the form of cash at a certain price per share. For example, if you own 100 shares of stock in a company that issues dividends at $0.50 per share, then you would receive a $50 dividend payment.

Some investors choose to reinvest dividends in additional company stock via a dividend reinvestment plan (DRIP). Instead of receiving dividends as cash, they’re used to automatically purchase fractional shares of common stock. Fractional shares are just what they sound like—a fraction of a share. Over time, fractional shares can add up to increase your overall investment in the company.

A less common way for companies to pay dividends is in the form of stock. Known as a scrip dividend, this allows investors to be paid a certain percentage of the number of shares they currently own. For example, if you own 100 shares of stock in a company that offers a 5% scrip dividend, you’d be given an additional five shares.

Ex-Dividend Dates

A company’s ex-dividend date is what determines whether a shareholder will receive a dividend. Shareholders who purchased a stock before the ex-dividend date will receive the next dividend payment while those who purchased the stock on or after the date will not.

If a shareholder didn’t purchase a stock in time to receive a dividend, then the investors who sold them the stock will.

Dividend Yield

The dividend yield is the amount that a company pays in dividends annually in relation to its stock price. To calculate the dividend yield of a particular stock, divide the dividend per share by the current share price. For example, if a company pays $1 per year and the stock’s price is currently $100, then your dividend yield is 1%.

The dividend yield is one factor you can consider when comparing several investments, but it’s not the only one.

Dividend yield is not necessarily representative of the company’s performance or the amount you’ll actually earn in dividends. For example, a company might have a high dividend yield because it generously rewards its shareholders, but it could also be because the company is underperforming and share prices are falling.

What It Means for Individual Investors

Whether a company chooses to pay dividends is of extreme importance to an investor because dividends are one of two primary ways to make money through stock investing.

First, consider whether dividends are important to you. Someone who invests primarily in growth stocks and plans to let their investments sit for many years may be less concerned with dividends. On the other hand, someone nearing retirement age or planning for early retirement might prefer dividend stocks.

It’s also important to consider how much a company pays in dividends. If you’re choosing between two different companies to invest in, you can look at each company’s dividend history to compare dividend yields and how much you might expect to earn.

You should also consider whether the companies you’re investing in pay ordinary or qualified dividends since this can impact your tax rate. Ordinary dividends are considered ordinary income and are taxed at your regular income tax rate. Qualified dividends are those that are:

  • Paid by a U.S. corporation or qualified foreign corporation
  • Not listed under the IRS list of non-qualified dividends
  • Held for a holding period of more than 60 days during the 121-day period that begins 60 days before the ex-dividend date

Qualified dividends are taxed as capital gains rather than income, which means you’ll pay a lower tax rate.

Frequently Asked Questions

How Often Are Dividends Paid?

Companies aren’t required to follow a particular dividend schedule, but they often pay them on a quarterly basis.

How Do I Calculate Dividend Yield?

The dividend yield of a stock is found by dividing the dividend-per-share amount by the stock’s current share price.

How Do I Reinvest My Dividends?

Reinvesting your dividends is a way to continue to increase your portfolio by purchasing more of your current holdings. You can reinvest your shares with a dividend reinvestment plan (DRIP) with your broker or with the company directly. Online brokerage firms typically have an account option to automatically reinvest dividends into additional stock shares.