What is a Dividend?
What Are Dividends - Definitions, Types & How They Work
Dividends are payments made by a company to its shareholders, usually on a quarterly basis. The company's board of directors determines if and when dividends will be paid out. Dividend payments come from the company's profits and are distributed to shareholders in the form of cash or additional shares. Companies may pay dividends as a reward to shareholders for investing in the company.
The dividend yield measures the dividend payment in terms of a percentage of the company's current share price. Investors seeking dividend income can choose stocks, mutual funds, and ETFs that pay dividends. While some view dividends as unimportant, they remain an attractive way for companies to provide additional value to shareholders.
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Which Companies Tend to Pay Dividends?
Companies may pay dividends to shareholders as a way of distributing profits. The board of directors determines when dividends are paid and how much they will be. Dividends are often paid on a quarterly basis, though some companies pay annually or semi-annually.
Larger, established companies with steady profits are more likely to pay dividends regularly. Industry sectors like those below maintain a history of regular dividend payments:
Basic materials
Oil and gas, banks
Healthcare
Pharmaceuticals
Utilities
Dividends may be paid in cash or additional shares of stock. Some view dividends as a sign that a company is profitable and shareholder-friendly. However, reducing or eliminating dividends could simply mean the company is investing profits into growth rather than issuing dividends. Overall, dividends provide a way for companies to reward shareholders while also signaling financial strength or changes in strategy.
Types of Dividend
There are several types of dividends a company can pay out to shareholders:
Cash dividends - The most common type of dividend. Companies pay these to shareholders directly in cash.
Stock dividends - Instead of cash, companies pay investors with additional shares of stock.
Dividend reinvestment programs (DRIPs) - With these programs, investors can reinvest any dividends received back into the company's stock, often at a discount. DRIPs are not mandatory - investors can still choose to receive the dividend in cash.
Special dividends - These dividends pay out on all shares of a company's common stock, but don't recur like regular dividends. A company often issues a special dividend to distribute profits accumulated over several years.
Preferred dividends - Payouts issued to owners of preferred stock. Preferred stock functions less like a stock and more like a bond. Dividends on preferred stock are usually paid quarterly, but unlike dividends on common stock, they are generally fixed.
Significant Dividend Dates to Know
Declaration date - This is when the company declares the dividend amount. The dividend must be approved by the Board of Directors by the declaration date before being paid out.
Ex-dividend date - The ex-date is the cutoff for buying the stock and qualifying for the upcoming dividend payment. Investors who purchase the stock on or after this date will not receive the dividend.
Record date - The company sets a record date to determine which shareholders are eligible to receive the dividend. Shareholders must own the stock prior to the record date in order to qualify for dividend payment.
Payable date - This is the date when the dividend payment is actually distributed and credited to investor accounts by the company. Only shareholders who owned the stock before the ex-date and are on record as of the record date will receive the dividend on the payable date.
How Do Companies Pay Dividends?
Picture this: If you possess 100 shares in a company, and that particular company distributes $1 as annual cash dividends per share, your yearly earnings from these dividends will amount to $100!
Dividends are paid out to shareholders through the following process:
1. First, a company earns profits through its business operations.
2. Next, the company's board of directors approves a plan to share those profits with shareholders in the form of dividends. Dividends are paid per share of stock. US companies usually pay dividends quarterly, monthly or semiannually.
3. The company then announces details about the upcoming dividend payment - when it will be paid, the dividend amount per share, and the ex-dividend date.
4. Investors must have initiated the purchase of the stock at least two business days before the ex-dividend date in order to be eligible for that dividend payment.
Why two business days: The settlement for the majority of stock trades takes place on the second business day after the execution of the order, which is commonly referred to as T+2 (trade date plus two days).
5. Finally, on the established payment date, the company distributes the dividend to all eligible shareholders. Those shareholders receive the dividend amount per share multiplied by the number of shares they own.
The ex-dividend date is very important. Investors must already own the stock by that date to receive the upcoming dividend. Investors who purchase the stock on or after that date will not qualify for that dividend payment.
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How to Evaluate Dividend
Here are a few key ways investors can potentially evaluate and compare dividends:
Dividend per share (DPS) - This metric shows the dollar amount of dividends distributed by the company for each share of stock during a certain time period. Tracking a company's DPS over time allows investors to see which companies are growing their dividends.
Dividend yield - This measures a company's annual dividend amount divided by the current stock price. It allows for comparison of dividend payments between stocks of different prices.
Dividend payout ratio - This ratio shows the portion of a company's net income that is paid out in dividends. It helps assess the safety and sustainability of the dividend. Investors generally look for payout ratios below 80%.
Dividend growth rate - This metric looks at the percentage growth in dividends over a certain time period, often annually. It helps identify companies with a history of consistently increasing their dividends.
Dividend aristocrats - This elite group of S&P 500 companies have increased their dividends annually for at least 25 consecutive years, showing reliability.
How Do Stock Dividends Dilute Share Price?
A stock dividend and a stock split both result in an increased number of shares outstanding, leading to a subsequent decrease in the stock price. In essence, both actions dilute the stock's value.
Stock prices are determined by dividing the firm's total value by the number of shares in circulation. For example, suppose a company boasts a market capitalization of $750 million with 200 million shares in circulation, equating to a stock price of $3.75 ($750/200). In the event of a 0.2 stock dividend declaration, the number of shares outstanding rises by 20% to 240 million.
Despite the company's market capitalization remaining constant, the share price undergoes a reduction to $3.13 ($750/240) with this revised number of shares outstanding.
How are Dividends Taxed?
All types of dividends received by investors are considered taxable income. However, there are two different tax rates that may apply:
Qualified Dividends refers to the dividends distributed by companies based in the U.S or traded within the U.S to shareholders who have held the stock for a minimum of 61 days. These qualified dividends are liable to be taxed at capital gains tax rates.
Ordinary dividends encompass all non-qualified dividend payments. This includes dividends paid by foreign companies not traded on U.S. exchanges. Ordinary dividends are taxed at the investor's regular federal income tax rate, which is typically higher than capital gains rates.