If you’re starting to invest in stocks, you’ve probably come across dividends. Wondering what is a dividend and how dividends work? A dividend is a portion of a company’s profits that are paid out to shareholders on a recurring basis. The percentage of earnings that is distributed to investors is determined by the company’s board of directors.
Not every company pays dividends to shareholders. Companies that pay dividends regularly are known as dividend paying companies, or dividend stocks. Investors buy dividend stocks to earn passive income, grow their portfolio, and build wealth. Some investors focus solely on dividend stocks and others use dividends to complement an overall strategy.
How Do Dividends Work?
Dividends are cash payments, or potentially additional shares of stocks, that are paid out to investors at a regular cadence. They are paid typically every quarter. Dividends are a way for investors to take part in a company’s growth by receiving a portion of that company’s profits.
Let’s say you own 10 shares of a company that pays $1 in dividend payments each quarter. You would receive $10 each quarter. Let’s assume you hold the stock for the entire year. You would receive a total of $40 in annual dividend cash dividends for that company.
Investors can choose whether to use their dividend cash payments as a source of passive income or reinvest the funds and buy more of that company’s stock. In either scenario, it’s common for dividend payments to be taxed.
Retired individuals oftentimes use dividend income to live on or supplement additional sources of income — such as social security. Many investors may also choose to reinvest their dividend payments into more stock shares to boost their investment portfolio.
How Often Are Dividends Paid?
The company’s board of directors decides how the company will pay its dividends and how often dividends are paid. The board of directors typically needs to receive shareholder approval through a vote when determining how much to pay out to shareholders.
Dividends can be paid out monthly, quarterly, or annually. Most companies in the United States will pay dividends every quarter.
Why Do Companies Pay Dividends?
Not every publicly traded company will distribute dividends to shareholders. Some companies will choose to use profits to invest into research and development, marketing, improving facilities, or other growth channels. Startups and fast-growing companies will be more focused on funding expansion rather than paying dividends.
Typically, larger and slower-growing companies will be more likely to pay dividends. Established companies with stable earnings may pay dividends. This is a way to prove to investors that their financials are sound and that the board of directors is confident about future earnings.
Companies that have consistently paid dividends and even increased their dividend payout over the years send a strong, positive message about that company’s durability and performance. Dividends can also make a company’s stock appear more attractive to investors.
Different Types Of Dividends
Not all dividends are created equal. It’s important to be aware of the different types of dividends and their implications. For starters, there are qualified dividends and nonqualified dividends.
A qualified dividend is from a stock that has been held for a certain period of time. Typically this time frame is at least 61 days after the ex-dividend date. This is the cutoff date for new shareholders to receive a dividend payment that quarter. Qualified dividends are taxed at a capital gains tax rate. Meanwhile unqualified dividend income is taxed at the regular income tax rate.
Aside from qualified and nonqualified dividends, there are two main types of dividends.
Unlike normal dividends which are paid on a regular basis, a special dividend is a one-time, non recurring payment. Special dividends are paid out when the company finds itself with a ton of excess cash on its hands. Companies might choose to distribute that extra cash among shareholders under certain circumstances. They include changing their financial structure, want to spin-off a subsidiary, or have enjoyed really powerful earnings
It’s important to note that special dividends are very rare and are not without their downsides. When companies pay a special dividend, they have subsequently seen their stock prices drop by the amount of the payment.
There are preferred stocks and common stocks. Preferred stocks are owned by shareholders who have a higher claim to the company. In the event of bankruptcy, preferred stockholders have priority over common stockholders. Preferred dividends are paid to owners of the company’s preferred stock, and offer a higher level of guarantee.
What Is Dividend Yield?
A dividend yield shows how much a company pays in annual dividends relative to its stock price. It’s a ratio that’s equivalent to annual dividends/stock price and is expressed as a percentage.
Say you own a company’s stock that’s trading at $100. Assume every quarter the company has paid $1 in dividend payouts, making its annual dividend $4. You would solve the equation of $4 ÷ $100 to find that the company has a dividend yield of 4%.
Dividends are always an important metric to consider when evaluating an investment decision. This holds true especially for value investors focused on dividend income. A higher yield means more income for shareholders.
Companies That Pay Dividends
Companies paying dividends are typically more established, larger businesses with stable earnings. Their board of directors feel confident enough that the business can sustain growth without reinvesting excess profits. These businesses are typically more solidified in their industries and aren’t focused on rapid growth.
In fact, most companies that pay dividends will stagnate behind growth stocks. This is especially true of aristocrat dividends that have consistently increased their dividend payout every year for the past 25 years. These companies are already mature and not investing heavily in expansion.
Whether or not you should implement a dividend investment strategy will depend on your overall financial goals and levels of risk. You may be in a position where maximizing passive income from dividends is ideal for your situation. Or you may be better to only diversify your portfolio with dividends.
A financial advisor is a professional that can help you identify your unique financial needs and develop an investment strategy accordingly. They can help you decide how many dividend-paying stocks you should include in your portfolio. They offer expert insight into which stocks to buy in addition. Learn more about how a financial advisor can help you reach your goals here.