Dividends are payments made by a company to its shareholders — here's how they work
- Dividends are periodic payments made to investors who own stock in a company, fund, or partnership.
- The payment of regular, ever-increasing dividends is seen as a sign of a well-run, healthy company.
- Large, mature companies tend to pay the biggest dividends.
Long before credit cards offered reward points, stocks offered dividends.
Dividends are a distribution of a company's earnings to shareholders — a little piece of the profits to those who have invested money in the firm. As with reward points, it's a monetary thank you to clients for doing business with them.
Dividends serve mutually beneficial purposes for both companies and investors, especially income-seeking investors. An indication of earnings, they reflect positively on a company and the management teams that consistently deliver them.
Regular, robust dividends earn trust from stockholders. As long as a company's shares maintain their dividend payout, investment dollars continue to pour into shares.
What is a dividend?
A dividend is a payment made to a company's stockholders. Business and financial entities like publicly traded companies, master limited partnerships, and real estate investment trusts issue dividends as a means of distributing their after-tax earnings to investors. Mutual funds and exchange-traded funds pay dividends as well.
Determined by a company's board of directors, dividends are calculated on a per-share basis. Usually, they're in the form of cash and deposited directly into an investor's financial account.
However, companies sometimes pay dividends with new shares of stock. And, in some cases, companies offer dividend reinvestment programs (DRIPs) that allow investors to apply the dividend toward the purchase of additional stock, often at a discounted price.
In the US, companies usually pay dividends each quarter. But payments can also occur monthly or semi-annually.
Stocks that pay dividends
Most dividend-paying companies are large-cap, well-established, and well-endowed businesses. These mature corporations don't need to reinvest earnings back into the business, the way small- and mid-cap companies or startups often do.
Industry sectors that are rich in dividend-paying companies — and whose companies pay rich dividends — include:
- Telecommunications
- Energy/Basic materials
- Financial
- Healthcare /pharmaceuticals
- Utilities
- Consumer staples
Kinds of dividends
Although all dividends come from the same source — the company earnings — the nature of their payouts depends on the class of shares you hold.
- Common dividends are paid to owners of a company's common stock. They can fluctuate in their amount each quarter (or whenever they're issued). It's in a company's interest to keep them increasing, or at least constant, but there are no guarantees.
- Preferred dividends are paid to owners of preferred stock. These are the same fixed amount; they don't fall, but they don't rise either. However, should a company run into financial trouble, preferred dividends hold priority over common dividends in the pecking order of payouts.
Occasionally, companies issue a special dividend — an extra payout to common stockholders. Special dividends usually are issued by firms who have either stockpiled a lot of cash over the years or experienced a windfall — from spinning off a subsidiary, for example. While often much larger than the regular variety, this "extra" dividend is a one-time thing.
Important dividend dates to know
There are some key dates surrounding dividends — especially pertaining to when a stockholder qualifies for them.
- Announcement date: The day management declares a dividend, which requires shareholder approval.
- Record date: The cutoff date, established by the company, that establishes share owner's eligibility for a dividend. This is when you must be on the company's books as a stockholder to receive the dividend.
- Ex-dividend date: The date, based on stock exchange rules, by which a shareholder must own stocks in order to receive a dividend for the payout period. It's usually set one business day before the record date. Shareholders who own a stock one business day before the ex-date receive a dividend payout. Shareholders who buy the stock on the ex-date or after — don't.
- Payment date: The date on which a company issues dividend payments, and shareholders receive the money in their brokerage accounts.
Are dividends taxed?
These dates are important not just because they determine whether you'll get a dividend payment, but also how it could be taxed.
In terms of taxes, dividends are classified in two ways:
- Qualified dividends are taxed at rates similar to capital gains: at 0%, 15%, or 20%.
- Non-qualified dividends are taxed as ordinary income, at your regular tax rate.
It depends on your tax bracket, of course, but the qualified rate is usually lower. And whether a dividend is qualified depends on how long you've owned the stock — 60 days before the ex-dividend date.
How are dividends evaluated?
Beyond the basic dollar amount, dividends are evaluated in a few different ways.
Dividend yield
In terms of valuing a dividend, investors look at a stock's dividend yield — the amount of the annual dividend divided by the stock price on a particular date. Measuring the dividend yield levels the playing field when comparing stocks and their dividend payouts.
For example, a stock with a $10 share price and a quarterly payout of 10 cents per share yields a 4% dividend. At the same time, a $100 stock that pays $1 per share, also on a quarterly basis, likewise yields a 4% dividend.
Yield and stock prices relate inversely to each other. As dividends increase, stock prices decrease. So dividend yields go up in one of two ways:
- A rise in the dividend payout: A company that pays a $4 dividend on a stock valued at $100 has a 4% dividend yield. A 10% increase in the dividend to $4.40 changes the dividend yield to 4.4% if the stock price remains static.
- A decrease in the stock price: Say, for instance, the price of a stock with a $4 dividend payout falls from $100 to $90. Without a change in the amount of the dividend, the 4% dividend yield climbs to just over 4.4%.
Dividend payout ratio
Beyond looking at a stock's dividend yield, however, savvy dividend investors look even more closely at the dividend payout ratio to gain a quick assessment of their reliability.
The payout ratio measures the portion of a company's net income that goes toward shareholder dividend payments. The higher the payout proportion, the lower the margin of safety. As a rule of thumb, investors look for payout ratios that fall below 80% of a company's net income.
Dividend-paying companies also incentivize investors seeking prudent financial vehicles. While stock investing often triggers capital gains implications, IRS accounting rules around dividend payments create a somewhat kinder, gentler tax hit. Rather than paying a higher capital gain rate, ordinary income rates apply to dividend payouts.
The financial takeaway
Dividends are lucrative for investors and prestigious for companies. They're a sign that the firm is doing well, so well it can afford to share profits with its investors. In fact, one of the characteristics of a blue-chip stock — the elite among publicly traded companies — is that it belongs to a company with an established record of growing dividends over decades.
Companies are not obligated to issue dividends, but once they do, investors expect them to continue, even in tough economic times. They also expect periodic increases. If a company announces a fall in the dividend payout one quarter, its stock price often takes a hit. And an outright suspension of dividends typically suggests a company is in trouble — and it may be time for investors to sell out.