A Beginner's Guide to How Dividends Work (2024)

Many people have wondered what it would be like to sit at home, reading by the pool, living off of the passive income that comes in the form of dividend checks.This dream can become a reality, but you must understand what dividends are, how companies pay them, and the different types of dividends that are available to you.

This beginner's guide will help you get started in the world of dividend investing.

What Are Dividends?

Companies that earn profit can either give all or some of that profit out to shareholders. They can also:

• Reinvest some of it in the business for growth.
• Acquire other companies for expansion.
• Invest in startups with novel ideas and products via their corporate venture arm.
• Use it for debt reduction.
• Allocate it toshare repurchases.

When part of the profit is paid out to shareholders, the payment is known as a "dividend." Dividends must be declared (i.e., approved) by a company’s board of directors each time they are paid. There are four important dates to remember regarding dividends:

• Declaration date: The declaration date is the day the board of directors announces its intention to pay a dividend.
• Ex-dividend date: This is the day—determined by the stock exchange—on which any new purchases of the stock are not entitled to the approved dividends (they would be up for the next round of dividends).
• Date of record: This date always follows the ex-dividend date. It is the day upon which the stockholders must be on the company's record books in order to be eligible to receive that period's dividend. It's basically the ex-dividend date on the company's side, whereas the previous date concerns the exchange itself.
• Payment date: This is the date the dividend will actually be given to the shareholders of the company.

Different Types of Dividends

Companies can decide to pay dividends in several different forms, from cash to additional stock shares.

Cash Dividends

Regular cash dividends are those paid out of a company’s profits to the owners of the business (i.e., the shareholders). A company that has preferred stock issued must make the dividend payment on those shares before a single penny can be paid out to the common stockholders. For reasons that will be discussed later, most companies are hesitant to increase or decrease the dividend on their common stock

Property Dividends

In the case of a property dividend, a company distributes property to shareholders instead of cash or stock. Property dividends are recorded at market value on the declaration date. They can take the form of railroad cars, cocoa beans, pencils, gold, silver, salad dressing, or any other item with tangible value.

Special One-Time Dividends

In addition to regular payouts, there are times when a company may pay a special one-time dividend. These are rare and can occur for a variety of reasons, such as a major litigation win, the sale of a business, or liquidation of an investment. They can take the form of cash, stock, or property dividends.

Stock Dividends

A dividend paid in stock shares rather than cash is a pro-rata distribution of additional shares of a company’s stock to owners of the common stock. A company may opt for stock dividends for a number of reasons, including inadequate cash on hand or a desire to lower the price of the stock on a per-share basis in order to prompt more trading and increase liquidity (i.e., how quickly an investor can turn their holdings into cash).

A Practical Example of Stock Dividends

Company ABC has one million shares of common stock. It has five investors who each own 200,000 shares. The stock currently trades at $100 per share, giving the business a market capitalization of $100 million.

Management decides to issue a 20% stock dividend. It prints up an additional 200,000 shares of common stock (20% of one million) and sends them to the shareholders based on their current ownership. All of the investors own 200,000 shares, or one-fifth of the company, so they each receive 40,000 of the new shares (one-fifth of the 200,000 new shares issued).

Now, the company has 1.2 million shares outstanding, and each investor owns 240,000 shares of common stock. The 20% dilution in the value of each share, however, results in the stock price falling to $83.33. Here’s the important part: the company (and our investors) are still in exactly same position. Instead of owning 200,000 shares at $100, they now own 240,000 shares at $83.33. The company’s market capitalization is still $100 million.

Evaluating Dividends

Whether high dividends are good or bad for you depends upon your personality and financial circ*mstances, and the business itself.

A company should only pay dividends if it is unable to reinvest its cash at a higher rate than the shareholders are able to if they receive a dividend. So, if company ABC is earning 30% on equity with no debt, the board should elect to retain all of the earnings, because the average investor probably won't find another company or investment that is yielding that kind of return.

At the same time, an investor may require cash income for living expenses. In that case, they are not interested in the long-term appreciation of shares; they want a check they can use to pay their bills.

Additional ways that companies and stockholders can evaluate dividends involve the payout ratio and dividend yield.

Dividend Payout Ratio

The percentage of net income that is paid out in the form of adividend is known as the "dividend payout ratio." This ratio is important in projecting the growth of the company because its inverse, known as the "retention ratio" (the amount not paid out to shareholders in the form of dividends), can help project a company’s growth.

In 2003, Coca-Cola's cash flow statement showed that the company paid $2.166 billion in dividends to shareholders. The income statement for the same year showed that the business had reported a net income of $4.347 billion. To calculate the dividend payout ratio, the investor would do the following:

Dividend Payout Ratio = $2,166,000,000 dividends paid /$4,347,000,000 reported net income.

The answer, 49.8%, tells the investor that Coca-Cola paid out nearly 50% of its profit to shareholders over the course of the year.

Dividend Yield

The dividend yield tells the investor how much they are earning on common stock from the dividend alone, based on the current market price. It is calculated by dividing the actual or indicated annual dividend by the current price per share.

The Dividend Tax Debate

Most dividends are taxed at a lower rate than normal income. So-called qualified dividends are taxed at the same rate as capital gains. For dividends to qualify for the lower rate, stocks generally must be held for at least 60 days.

Selecting High-Dividend Stocks

An investor who desires to put together a portfolio that generates high dividend income should place great scrutiny on a company’s dividend payment history. Only those corporations with a continuous record of steadily increasing dividends over the past 20 years or longer should be considered for inclusion. Furthermore, the investor should be convinced that the company can continue to generate the cash flow necessary to make the dividend payments.

Dividends Depend on Cash Flow

Dividends are dependent upon cash flow, not reported earnings. Almost any board of directors would still declare and pay a dividend if cash flow were strong, but the company had a net loss on its income statement. The reason is simple: investors who prefer high-dividend stocks look for stability.

A company that lowers its dividend will probably experience a decline in the stock price as jittery investors sell and take their money elsewhere. Accordingly, companies will not raise the dividend rate just because of one successful year. Instead, they will wait until the business is capable of generating the cash to maintain the higher dividend payments. Likewise, they will not lower the dividend simply because they think the company is facing temporary problems.

Dividend Reinvestment Plans (DRIPs)

Unless you need the money for living expenses or are an experienced investor who regularly allocates capital, the first thing you should do when you acquire a stock that pays a dividend is to enroll it in a dividend reinvestment plan, or "DRIP" for short.

How Dividend Reinvestment Plans Work

When an investor enrolls in a dividend reinvestment plan, they will no longer receive cash dividends in the mail or directly deposited into their brokerage account. Instead, those dividends will be used to purchase additional shares of stock in the company that paid the dividend. There are several advantages to investing in a DRIP:

• Enrolling in a DRIP is easy. The paperwork (both online and in print) can normally be filled out in under one minute.
• Dividends are automatically reinvested. Once the investor has enrolled in a DRIP, the process becomes entirely automated and requires no more attention or monitoring.
• Many dividend reinvestment plans are part of a direct stock purchase plan. If you hold at least one share directly, you can have your checking or savings account automatically debited on a regular basis to purchase additional shares of stock.
• Purchases through dividend reinvestment programs are normally subject to little or no commission.
• Dividend reinvestment plans allow you to purchase fractional shares instead of only whole shares. Over the decades, that can result in significantly more wealth in the investor's hands.
• You can enroll only a limited number of shares in the dividend reinvestment plan and continue to receive cash dividends on the remaining shares.

Full DRIP Enrollment

Consider an example: Jane Smith owns 1,000 shares of XYZ Company. The stock trades at $47 per share, and the annual dividend is $1.56 per share. The quarterly dividend of39 cents per share has just been paid.

Before she enrolled in XYZ’s dividend reinvestment plan, Jane would normally receive a cash deposit of $390 in her brokerage account. This quarter, however, she logs into her brokerage account and finds that she now has 1,008.29 shares of XYZ. The $390 dividend that was normally paid to her was reinvested in whole and fractional shares of the company at $47 per share.

Partial DRIP Enrollment

Now, let's look at a partial DRIP enrollment. William Jones owns 500,000 shares of EZ Group. The stock trades at $49 and pays an indicated annual dividend of $3.20 per share ($0.80 per quarter). William would like to receive some cash for living expenses but enroll some of the shares in a DRIP. He calls his broker and has 300,000 shares enrolled in EZ’s DRIP.

When the quarterly dividend is paid, William will receive cash dividends of $160,000. He will also receive 4,898 additional shares of EZ Group, which will give him holdings of 504,898 shares.

300,000 shares x $0.80 dividend = $240,000 / $49 per share price = 4,898 new shares of EZ Group.

Dividends on Dividends

Why are dividend reinvestment plans conducive to wealth building? Notice that William now has 4,898 additional shares of EZ Group stock. When the next quarterly dividend is paid, he will receive $0.80 for each of those shares. Imagine the wealth that you can grow as dividends turn into new shares, which produce dividends, and the pattern repeats.

Ready to Go Further With Dividends?

That's only the begging of dividend investing. Once you've grasped these concepts, you'll be ready to move on to"The Ultimate Guide to Dividend Investing." There, you'll learn advanced dividend strategies, how to avoid dividend traps, how to use dividend yields to tell whether stocks are undervalued, and much more.

Frequently Asked Questions (FAQs)