What are dividends and how do they work?

Highlights

• Dividends are regular payments of profit made to investors who own a company’s stock, distributed based on each shareholder’s stake in the company.
• Whereas most companies pay a dividend four times a year on a quarterly basis, others pay theirs on an annual basis. Payments may be made out as cash or in the form of additional stock.
• Companies may decide to pay dividends for several reasons. Corporations that make large profits will have sufficient funds to both use it to reinvest in itself and pay out dividends. Dividends are also paid out as a form of reward to shareholders for providing the capital.
• Growth companies tend to retain their earnings so that they can reinvest their profits for further growth, however, mature and established corporations with predictable profits often pay dividends.
• The board of directors must decide the various time frames by which the dividends must be paid and the different payout rates. The declaration date, ex-dividend date, date of record and payment date should be kept in mind.
• Dividends are typically paid out on a company’s common stock, however, there are several different types of dividends, such as cash, stock, special and preferred dividends, as well as DRIPs (dividend reinvestment programmes).
• The dividend per share (DPS), the dividend payout ratio and the dividend yield are all metrics used to evaluate dividends.
• The DPS showcases the amount of dividends distributed by the company for each share of stock during a certain time period, whereas the dividend payout ratio is the proportion of earnings paid out as dividends to shareholders. The dividend yield is the amount of money a company pays shareholders for owning a share of its stock divided by its current stock price.
• Interested to discover more about dividend investing? Get in touch with our financial advisors who can help you make the right financial decisions based on your individual needs.

For many investors, using regular dividends to reinforce their income is the ultimate goal. And whereas dividends can offer a steady flow of income, they are also an excellent means of compounding if dividends are reinvested. At the same time, they are one of the simplest ways for companies to foster goodwill among their shareholders, drive demand for their stock and showcase financial well-being and shareholder value.

Below we delve deeper into dividends and how they work, why companies pay them, the different types, as well as the metrics used to evaluate them so that you can make the most out of your investment.

What are dividends?

Companies that make a profit can pay that out to shareholders or they may reinvest it in the business for expansion, debt reduction or share repurchases. When part of this profit is paid out to shareholders, it is known as a dividend. Dividend payments are made as a reward to investors for putting their money into the company. Having said that, along with publicly-listed companies, a number of mutual funds, as well as exchange-traded funds (ETFs) also pay dividends. Not sure what ETFs are? Have a look at our guide. – link to respective article

Dividends are distributed based on each shareholder’s stake in the company, offering them a certain sum of money per each share they own. Payments may be made out as cash or in the form of additional stock. So if, for instance, Apple announces a dividend of $0.60 per share, a stockholder who owns 50 shares of the company will receive a $30 dividend. Typically, dividends are paid four times a year on a quarterly basis, so if a corporation pays a $0.88 dividend per share, it will actually provide $0.22 per share four times a year. Other companies may pay dividends on an annual basis.

A company’s board of directors determines what percentage of the earnings will be used to pay dividends.

Why do companies pay dividends?

There are several reasons why a company will opt to pay a dividend, however, it is important to remember that paying one is not an obligation. In fact, Facebook, Amazon, Google, Telsa and several other companies do not pay dividends.

The company makes sufficient profit:

Whereas some companies may not generate enough profits and so they simply cannot afford to pay dividends, profitable companies may have enough earnings to both make additional acquisitions, invest in growth opportunities, pay down debt or buy back their own shares and pay dividends to its shareholders. It may also be the case that a mature company with stable earnings does not need to reinvest as much in itself.

The company is obliged to serve the shareholder:

An investor typically buys a company’s stock to make and earn a profit. In fact, many investors opt for stocks and other financial products that offer a dividend because they enjoy the steady income. Dividends are paid to reward their shareholders for providing them with the capital to run their business and ultimately, dividend payments serve as a reflection of a company’s future prospects and performance and this could potentially make their stock more attractive.

Which companies pay dividends?

Generally speaking, growth companies tend to retain their earnings since they often need to reinvest their profits into further growth. In particular, start-ups and high-growth companies such as those in the technology or biotech sectors, may be in the early stages of development and may have to deal with high costs either due to research and development, business expansion and operational activities or they may simply not have sufficient funds to issue dividends. On the other hand, their more mature counterparts are more likely to offer dividend payouts. In effect, established companies with predictable profits are often considered the best dividend payers.

Historically, companies in industry sectors such as utilities, healthcare and pharmaceuticals, banks and financial, oil and gas, as well as basic materials tend to maintain a regular record of dividend payments, while other sectors are known to pay more dividends than others.

What is the dividend process like?

Dividends must be declared by a corporation’s board of directors each time they are paid. The board must also decide the various time frames by which the dividends must be paid and the payout rates. At times, companies may also decide to issue special, one-time dividends either individually or in addition to a scheduled dividend. For instance, back in 2004, Microsoft Corp declared a special dividend of $3 per share, way above the usual quarterly dividend at the time which was in the range of $0.08 to $0.16 per share.

Which dividend dates are important?

Dividend payments follow a chronological order and each associated date is important since it determines the shareholders who qualify to receive the dividend payment. There are four important dates to remember. These include:

Declaration date: this date earmarks the announcement by the company’s board of directors on their intention to pay a dividend. Typically, the board also declares the size of the dividend, the ex-dividend, as well as the payment date.

Ex-dividend date: this date signals when eligibility expires and it signifies that the stock starts trading without the value of its next dividend payment. Only the owners of shares before the ex-dividend date will actually receive the dividend.

Date of record: is when the company goes through its records to evaluate who is eligible to receive the dividend. The record date usually takes place one businesses day following the ex-dividend date.

Payment date: this is the date when the dividend will actually be paid to the shareholders of the company.

Are there different types of dividends?

Dividends are typically paid out on a company’s common stock, however, there are several different types of dividends a company can choose to pay out to its shareholders. Here is just a list of some of them.

Cash dividends – one of the most common types of dividend, regular cash dividends are those paid in cash out of a company’s profits directly into the shareholders’ brokerage account.

Stock dividends – instead of paying cash, companies may also pay investors with additional shares of stock. A dividend paid in stock is a pro-rata distribution of additional shares of a company’s stock to owners of the common stock. Companies may opt to pay out stock dividends either because they do not have sufficient cash on hand or because they want to lower the price of the stock on a per-share basis to boost more trading and increase liquidity.

Special dividends – occasionally, a company may decide to pay a special one-time dividend in the form of cash, stock or property dividends. This can take place for several reasons, such as a company distributes profits that have accumulated over several years and for which it has no immediate need.

Preferred dividends – these dividends are cash dividends paid to a company’s preferred shareholders. Preferred stocks function more like a bond and less like a stock, with dividends usually paid on a quarterly basis and unlike common stock, dividends are generally fixed. If a company is unable to pay all dividends, preferred dividends are paid out before those on common shares.

DRIPs (dividend reinvestment programmes) – DRIPs allow investors to reinvest their cash dividends into the company’s stock or into fractional shares of the underlying stock on the dividend payment date.

How to evaluate dividends

As mentioned earlier on, investors may choose stocks, mutual funds or ETFs to receive dividends. But how can you assess the dividends? The dividend yield factor, the dividends per share and the dividend income are all important performance measures to assess the dividend payment performance and the returns generated.

Dividend per share (DPS)

The DPS showcases the amount of dividends distributed by the company for each share of stock during a certain time period. This metric is important because it allows investors to determine which companies are able to grow their dividends over time. Established, dividend-paying companies tend to have a steady DPS growth and it goes without saying that these companies tend to be very much sought after. For example, Walmart has steadily increased its annual cash dividend every single year since it first began to pay one out in 1974. Since 2015, the retailer has added at least 4 cents each year to its dividend per share, eventually raising that to $2.08 for its fiscal year 2019.

Dividend payout ratio

The dividend payout ratio is the proportion of earnings paid out as dividends to shareholders, typically showcased as a percentage. This ratio is crucial when it comes to projecting the growth of the company. New and growth-orientated companies focused on reinvesting most or all of its earnings is expected to have a low or zero payout ratio. To calculate the dividend payout ratio, you must divide the dividend per share by the earning per share. Alternatively, the dividends can be divided by the net income.

Dividend yield

Displayed as a percentage, the dividend yield is the amount of money a company pays shareholders for owning a share of its stock divided by its current stock price. Assuming that the dividend is not raised or lowered, then the yield will rise when the price of the stock falls and in contrast, it will fall when the price of the stock rises.

Stable dividends are crucial in helping companies keep their stock price strong, while dividend-paying companies will do their outmost to maintain a healthy financial position. For investors, dividends can generate a steady source of passive income, while you can take full advantage of compounding by using your dividend earnings to purchase additional shares which in turn will provide their own regular dividend payout. And the longer you continue to reinvest, the more quickly your returns will grow.

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Interested to discover more about dividend investing? Get in touch with our financial advisors who can help you make the right financial decisions based on your individual needs.