The stock market is known to be a compelling place to build wealth and create a comfortable retirement. One of the reasons the market is able to assist in doing so is because several publicly traded companies pay dividends.
These dividends often make up much of the income retirees live off of and can help you build up a meaningful nest egg through your working career. Dividends are also a great sign of strength when looking for solid companies to invest in.
But what exactly are dividends and how do they work?
What Are Dividends?
Dividends are distributions of a percentage of a company’s retained earnings to its shareholders. In other words, dividends are direct payments from a company to its shareholders.
There is no requirement for companies to share their earnings with their stockholders, and not every publicly traded company offers dividends. Nonetheless, more than 84% of companies listed on the S&P 500 pay dividends, according to Forbes.
Dividends must be declared by the company’s board of directors, which often consists of C-level management, large investors, and industry experts. When declaring a dividend, the board of directors will inform investors when the dividends will be paid and how much money will be provided to shareholders per share owned.
Why Dividends are Important
There are several advantages to investing in companies that pay dividends. Some of the reasons these distributions of earnings are so important include:
- Sign of Strength. Dividend-paying stocks generally represent well-established companies with enough liquidity to handle most financial burdens that might come their way. As a result, they’re comfortable sharing their free cash flow with investors rather than retaining it in an effort to build up the equivalent of a corporate emergency fund.
- Second Opportunity for Growth. Investors earn returns when a company’s stock price heads in the right direction, but dividends also add to that return, creating a second opportunity to expand overall growth.
- Expand the Power of Compounding Gains. Investors can choose to spend their dividends, but most will benefit greatly from reinvesting them. By reinvesting dividends, investors increase their holdings in the companies they invest in with money provided by the companies themselves. These reinvestments are the ultimate way to expand the power of compounding gains on Wall Street.
- Income. Retirees and other investors that are dependent on the income from their investments often depend heavily on dividend income. Rather than selling stock to make ends meet, these investors invest in high-dividend paying stocks and receive regular payments that cover day-to-day expenses.
How Stock Dividends Work
The process starts with a company’s board of directors declaring a dividend, including the amount to be paid per share, and the date at which investors can expect payments. The board of directors will also outline an ex-dividend date.
Shareholders that owned shares at least one business day prior to the ex-dividend date will be included in the dividend payments.
There are a couple of ways dividends work, depending on the types of investments you own.
If you invest in individual dividend-paying stocks, the payments are relatively straightforward. You’ll receive your cut of the company’s profits on the date announced by the company’s board of directors.
The size of the payment you’ll receive depends on the number of shares of stock you own and the amount of the dividend announced. For example, if you own 100 shares of ABC stock, and the company declares a dividend of $0.10 per share, you’ll receive $10 when dividend payments are dispersed.
ETFs & Mutual Funds
Exchange-traded funds (ETFs) and mutual funds pool investment dollars from a large group of investors and use those dollars to invest according to the fund’s prospectus. Shareholders in the fund take part in both the price appreciation and dividend payments generated by the stocks held in its portfolio.
When companies pay dividends on shares held in investment-grade funds, those dividends are divided among the investors in the fund based on the number of shares of the fund owned.
For example, say you own 100 shares of ABC fund, which has one million shares outstanding and owns 100 million shares of ABC stock. When ABC stock pays a $0.10 dividend, the fund will receive $10 million that will then be divided among its one million shares, working out to a total dividend payment of $10 per share.
Types of Dividends
Dividend-paying companies don’t always pay dividends in cash. Moreover, the type of dividend you receive also depends on the type of stock you hold. You’ll find a list of the different types of dividends in existence today below:
Cash dividends are a distribution of a percentage of a company’s profits to its shareholders, paid in cash.
Cash dividends are the most common and straightforward type of dividend payouts. Shareholders simply receive a cash payment in proportion to the number of shares they own. Payments are made directly to the investor’s brokerage account, where they can elect to keep the cash or reinvest it (more on this later).
Stock dividends are a distribution of a predetermined number of shares of stock to shareholders. There are two different types of stock dividends that exist:
- Additional Shares. In some cases, a corporation will send shareholders additional shares of its own stock.
- Invested Shares. In other cases, a company may pay its shareholders dividends by giving them shares of stock it owns in another company.
A special dividend is a form of dividend paid to investors that’s separate from the company’s regular, recurring dividends. These are generally one-time payments resulting from mergers and acquisitions or profits that dramatically beat expectations.
Special dividends can be paid to investors in the form of cash or shares of stock.
Preferred dividends are dividend payments that are allocated to preferred stockholders. Preferred shares generally come with fixed dividends, unlike common stock dividends, which generally fluctuate with corporate profitability.
Investors who own preferred stock receive their dividend payments first. Should the company find that there’s not enough money to go around, preferred shareholders will be paid preferred dividends before common shareholders receive any dividend payments.
Dividend Reinvestment Plans (DRIPs)
Dividend reinvestment plans (also called dividend reinvestment programs or DRIPs) are programs that automatically use dividends a stock, ETF, or mutual fund pays to investors to purchase additional shares.
DRIPs are best for investors who aren’t drawing from the income generated through their investment portfolios. Instead, these investors can reinvest dividends to accumulate more shares, fueling compounding gains.
The best part is that DRIPs have become so commonplace that most brokers offer the reinvestment of dividends as a standard, commission-free service.
There are multiple dates that are important to understand when investing for dividends. These dates include:
- Declaration Date. The declaration date of a dividend is the date the company announced (declared) it would be coming.
- Ex-Dividend Date. The ex-dividend date is dictated by stock exchange rules and is important because it determines who will be paid the dividend. Investors must own shares the business day prior to the ex-dividend date to qualify for the dividend payments. The ex-dividend date is the date at which the company’s stock will trade without the value of its dividend — hence “ex-dividend.”
- Record Date. The record date, or date of record, is the date that shareholders must own shares to receive payments. Record dates are dictated by the company and are the exact date shareholders must be on board.
- Payment Date. The payment date, also called the payable date, is the day on which the company will transfer the dividend payment into its shareholders’ brokerage accounts. Usually the payment date is just a few days after the ex-dividend and record dates, but can be up to one month later.
How Often Are Dividends Paid?
Dividends can be paid monthly, quarterly, annually, or on a one-time basis. Annual dividends are paid once per year, whereas regular dividends are paid out in equal increments over the course of the year. These payments start on the payment date given in the dividend declaration.
Companies may also pay a special dividend on a one-time basis outside of its standard dividend payment schedule.
Stocks That Pay Dividends
There are a long list of stocks that pay dividends. Not only do most of the big companies listed on the S&P 500 make regular payments to investors, but U.S. News & World Report also says around 53% of global small-cap stocks do too.
Some of the best industries in which to find high dividend-paying stocks include:
Utilities are a necessity. You’re not going to have a comfortable life if you don’t have electricity and access to clean water, so these are services that tend to retain customers even during bad economic times.
As a result, utilities companies often have stable, slow-growing stocks. These companies know how many people use their services, can easily predict their income range and the cost of infrastructure maintenance.
Although utilities companies use some of their earnings on infrastructure, they don’t need to invest heavily in constant, expensive innovation. Many can afford high dividend payout ratios, resulting in large and consistent dividend payments to investors.
Consumer staples are goods and services that people use daily, including items like food, personal hygiene products, and cleaning supplies.
The companies that offer these products benefit from a high level of demand and predictability. Like utilities, consumer staples companies don’t have to spend massive amounts of money on innovation to maintain their positions in their industries. These companies often share a large portion of their earnings with investors through dividend payments.
The financial services industry is another known for high dividend payers. Financial service companies provide services that most people need like checking, savings, and investment accounts.
These companies focus their efforts on providing quality services rather than spending on innovation to stay ahead of the curve. As a result, many financial service companies pay larger dividends to investors than companies in other sectors.
How to Calculate Dividend Yield & Dividend Payout Ratio
Dividend yield and dividend payout ratio sound like similar ideas but they measure two entirely different metrics.
The dividend yield on a stock or investment fund is the amount of money investors receive annually in relation to the share price. By contrast, the dividend payout ratio is the percentage of retained earnings a company shares with its investors.
Here’s how each is calculated:
The formula for the dividend yield is:
Annual Dividend Payments ÷ Share Price = Dividend Yield
So, if a stock costs $50 per share and offers an annual dividend of $1 per share, the formula would look like this:
$1 ÷ $50 = 2%
This means the stock has an annual dividend yield of 2%. Remember, if the stock pays its dividend quarterly, the annual dividend payment amount is the sum of the four quarterly payments.
Dividend Payout Ratio
The formula for the dividend payout ratio is as follows:
Total Dividends ÷ Total Earnings = Dividend Payout Ratio
For example, if a company earned $100 million after taxes last year and paid out $50 million in dividends, the formula for its dividend payout ratio would look like this:
$50 million ÷ $100 million = 50%
At first glance, a high dividend payout ratio may seem like a great thing. However, it’s important for companies to retain enough of their earnings for investments into areas like research & development, basic materials, and building a larger workforce. Therefore, dividend payout ratios that are too high aren’t usually sustainable for long periods of time.
How Dividends Are Taxed
The amount you’ll be taxed on your dividend payments depends on whether they’re recognized as qualified dividends or ordinary dividends. Here’s the difference between the two:
Qualified dividends are taxed at the long-term capital gains tax rate, which maxes out at 20%. Qualified dividends must meet a set of criteria set in place by the IRS to qualify for taxation at the lower capital gains tax rate.
To be treated as qualified dividends, the company paying them must be a U.S. corporation, an international organization whose stock is readily traded on a U.S. stock exchange, or a foreign company eligible for special dividend taxation under the Comprehensive Income Tax Treaty.
To receive the better tax treatment of qualified dividends, common stockholders must have owned their shares for a minimum of 60 days during the 121 day period that starts 60 days before the ex-dividend date. For preferred stockholders, dividends are only qualified if the investor has held the stock for 90 days of the 181-day period starting 90 days prior to the ex-dividend date.
Ordinary dividends are taxed at the investor’s standard income tax rate because they don’t qualify for capital gains-related discounts.
Dividends from investments like real estate investment trusts (REITs), employee stock options, and master limited partnerships are all considered ordinary dividends.
Dividends are an important part of investing. Not only are they an opportunity to generate income from the stock market, but they also offer investors a way to expand the power of compounding gains.
If you decide to invest in dividend stocks, it’s important to take the time to do your research. Although dividend stocks are generally perceived to be safe investments, even the strongest companies fall on hard times, and you don’t want to be in their way when they do. Moreover, different stocks come with higher or lower yields, historic price appreciation, and future prospects.