Dividends: Definition in Stocks and How Payments Work (2024)

What Is a Dividend?

A dividend is the distribution of a company's earnings to its shareholders and is determined by the company's board of directors. Dividends are often distributed quarterly and may be paid out as cash or in the form of reinvestment in additional stock.

The dividend yield is the dividend per share and is expressed as dividend/price as a percentage of a company's share price, such as 2.5%.

Common shareholders of dividend-paying companies are eligible to receive a distribution as long as they own the stock before the ex-dividend date.

Key Takeaways

A dividend is the distribution of corporate earnings to eligible shareholders.
Dividend payments and amounts are determined by a company's board of directors.
The dividend yield is the dividend per share, and expressed as a percentage of a company's share price.
Many companies do not pay dividends and instead retain earnings to be invested back into the company.

Dividends: Definition in Stocks and How Payments Work (1)

Understanding Dividends

Dividends must be approved by the shareholders by voting rights. Although cash dividends are common, dividends can also be issued as shares of stock. Various mutual funds and exchange-traded funds (ETFs) also pay dividends.

A dividend is a reward paid to the shareholders for their investment in a company’s equity, and it usually originates from the company's net profits. For investors, dividends represent an asset, but for the company, they are shown as a liability. Though profits can be kept within the company as retained earnings to be used for the company’s ongoing and future business activities, a remainder can be allocated to the shareholders as a dividend.

Dividend-Paying Companies

Larger, established companies with predictable profits are often the best dividend payers and the following industry sectors maintain a regular record of dividend payments:

Basic materials
Oil and gas
Banks and financial
Healthcare and pharmaceuticals
Utilities

Companies structured as master limited partnerships (MLPs) and real estate investment trusts (REITs) require specified distributions to shareholders. Funds may also issue regular dividend payments as stated in their investment objectives.

Startups, such as those in the technology or biotech sectors, may not offer regular dividends since these companies may be in the early stages of development and retain earnings for research and development, business expansion, and operational activities.

Important Dividend Dates

Dividend payments follow a chronological order of events, and the associated dates are important to determining which shareholders qualify to receive the dividend payment.

Announcement date: Dividends are announced by company management on the announcement date (or declaration date) and must be approved by the shareholders before they can be paid.
Ex-dividend date: The date on which the dividend eligibility expires is called the ex-dividend date or simply the ex-date. For instance, if a stock has an ex-date of Monday, May 5, then shareholders who buy the stock on or after that day will NOT qualify to receive the dividend. Shareholders who own the stock one business day prior to the ex-date, on Friday, May 2, or earlier, qualify for the distribution.
Record date: The record date is the cutoff date, established by the company to determine which shareholders are eligible to receive a dividend or distribution.
Payment date: The company issues the payment of the dividend on the payment date, which is when the money gets credited to investors' accounts.

How Do Dividends Affect a Stock's Share Price?

As an example, a company that is trading at $60 per share declares a $2 dividend on the announcement date. As the news becomes public, the share price may increase by $2 and hit $62.

If the stock trades at $63 one business day before the ex-dividend date. On the ex-dividend date, it's adjusted by $2 and begins trading at $61 at the start of the trading session on the ex-dividend date, because anyone buying on the ex-dividend date will not receive the dividend.

Why Do Companies Pay Dividends?

Dividends are often expected by the shareholders as a reward for their investment in a company. Dividend payments reflect positively on a company and help maintain investors’ trust.

A high-value dividend declaration can indicate that the company is doing well and has generated good profits. But it can also indicate that the company does not have suitable projects to generate better returns in the future. Therefore, it is utilizing its cash to pay shareholders instead of reinvesting it into growth.

A company with a long history of dividend payments that declares a reduction of the dividend amount, or its elimination, may signal to investors that the company is in trouble. AT&T Inc. cut its annual dividend in half to $1.11 on Feb. 1, 2022, and its shares fell 4% that day.

However, a reduction in dividend amounts or a decision against a dividend payment may not necessarily translate into bad news for a company. The company's management may have a plan for investing the money such as a high-return project that has the potential to magnify returns for shareholders in the long run.

Fund Dividends

Dividends paid by funds, such as a bond or mutual funds, are different from dividends paid by companies. Funds employ the principle of net asset value (NAV), which reflects the valuation of their holdings or the price of the assets that a fund has in its portfolio.

Regular dividend payments should not be misunderstood as a stellar performance by the fund. For example, a bond-investing fund may pay monthly dividends because it receives monthly interest on its interest-bearing holdings and merely transfers the income from the interest fully or partially to the fund's investors.

A stock-investing fund pays dividends from the earnings received from the many stocks held in its portfolio or by selling a certain share of stocks and distributing capital gains.

Are Dividends Irrelevant?

Economists Merton Miller and FrancoModigliani argued that a company's dividend policy is irrelevant and has no effect on the price of a firm's stock or its cost ofcapital. A shareholder may remain indifferent to a company’s dividend policy as in the case of high dividend payments where an investor can just use the cash received to buy more shares.

If a dividend payout is lean, an investor can instead sell shares to generate the cash they need. In either case, the combination of the value of an investment in the company and the cash they hold will remain the same. Miller and Modigliani thus conclude that dividends are irrelevant, and investors shouldn’t care about the firm's dividend policy because they can create their own synthetically. However, dividends remain an attractive investment incentive, with additional earnings made available to shareholders.

How to Buy Dividend-Paying Investments

Investors seeking dividend investments have several options, including stocks, mutual funds, and exchange-traded funds (ETFs). The dividend discount model or the Gordon growth model can help choose stock investments. These techniques rely on anticipated future dividend streams to value shares.

To compare multiple stocks based on their dividend payment performance, investors can use the dividend yield factor, which measures the dividend in terms of a percentage of the current market price of the company’s share.

The dividend rate can be quoted in terms of the dollar amount each share receives as dividends per share (DPS). In addition to dividend yield, another important performance measure to assess the returns generated from a particular investment is the total return factor. This figure accounts for interest, dividends, and increases in share price, among other capital gains.

Tax is another important consideration when investing in dividend gains. Investors in high tax brackets often prefer dividend-paying stocks if their jurisdiction allows zero or comparatively lower tax on dividends. For example, Greece and Slovakia have a lower tax on dividend income for shareholders, while dividend gains are tax exempt in Hong Kong.

How Often Are Dividends Distributed to Shareholders?

Dividends are commonly distributed to shareholders quarterly, though some companies may pay dividends semi-annually. Payments can be received as cash or as reinvestment into shares of company stock.

What Is an Example of a Dividend?

If a company's board of directors decides to issue an annual 5% dividend per share, and the company’s shares are worth $100, the dividend is $5. If the dividends are issued every quarter, each distribution is $1.25.

Why Are Dividends Important?

Though dividends can signal that a company has stable cash flow and is generating profits, they can also provide investors with recurring revenue. Dividend payouts may also help provide insight into a company’s intrinsic value. Many countries also offer preferential tax treatment to dividends, where they are treated as tax-free income.

As a seasoned financial expert deeply immersed in the world of investments, particularly in dividend-paying instruments, I bring a wealth of firsthand knowledge and a comprehensive understanding of the intricacies surrounding dividends. Over the years, my expertise has been honed through extensive research, practical experience, and a keen eye for market trends.

Let's delve into the key concepts presented in the article:

1. Dividend Basics:

A dividend is the distribution of a company's earnings to its shareholders.
Determined by the company's board of directors.
Usually distributed quarterly as cash or reinvested in additional stock.
Dividend yield is expressed as a percentage of the company's share price.

2. Dividend Approval and Types:

Dividends must be approved by shareholders through voting rights.
Dividends can be issued as cash or shares of stock.
Mutual funds and ETFs also pay dividends.

3. Dividend Allocation and Frequency:

Dividends are a reward for shareholders, originating from a company's net profits.
Considered an asset for investors but a liability for the company.
Companies may make dividend payments even in the absence of suitable profits.
Board of directors decides on dividend issuance time frames and payout rates.

4. Dividend-Paying Companies:

Larger, established companies in sectors like basic materials, oil and gas, banks, healthcare, and utilities are often reliable dividend payers.
MLPs and REITs require specified distributions to shareholders.

5. Important Dividend Dates:

Announcement date, ex-dividend date, record date, and payment date are crucial in the dividend payment process.

6. Impact on Stock Price:

Example: Stock trading at $60 declares a $2 dividend, causing the share price to potentially increase to $62.
Adjustment on the ex-dividend date may lead to changes in stock price.

7. Reasons for Dividend Payments:

Dividends are a reward for investment and positively reflect a company's performance.
High-value dividends may indicate financial health, but companies may lack profitable projects.
Reduction or elimination of dividends can signal company trouble.

8. Fund Dividends:

Dividends from funds differ from company dividends.
Funds use NAV to reflect their valuation.
Example: Bond funds may pay monthly dividends from interest received.

9. Dividend Irrelevance Hypothesis:

Economists Miller and Modigliani argue that a company's dividend policy is irrelevant to its stock price or cost of capital.
Investors can create their own synthetic dividends.

10. How to Buy Dividend-Paying Investments:

Options include stocks, mutual funds, and ETFs.
Dividend discount model and Gordon growth model help in stock selection.
Dividend yield and total return factor are essential performance measures.
Consideration of tax implications is crucial, with some jurisdictions offering preferential treatment for dividend income.

11. Frequency of Dividend Distribution:

Dividends are commonly distributed quarterly, but some companies may pay semi-annually.

12. Example of a Dividend:

If a company issues an annual 5% dividend per share and shares are worth $100, the dividend is $5. Quarterly distributions would be $1.25.

13. Importance of Dividends:

Signal stability, generate recurring revenue, and provide insight into a company’s intrinsic value.
Preferential tax treatment in many countries.

With this comprehensive understanding, investors can navigate the intricate landscape of dividends, making informed decisions aligned with their financial goals.