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Dividends are payments a company makes to share profits with its stockholders. They’re one of the ways investors can earn a regular return from investing in stocks.
Dividends can be paid out in cash, or they can come in the form of additional shares. This type of dividend is known as a stock dividend.
Dividend yield is the company’s annual dividend divided by the stock price on a certain date. Investors use the dividend yield to be able to accurately compare dividend stocks. Dividend payout ratios are also an important measure that tell you how much of a company’s income is put towards dividends versus reinvesting in the company.
But not all stocks pay dividends. If you are interested in investing for dividends, you will want to specifically choose dividend stocks. Companies that increase their dividend payments year after year are usually less volatile than the broader market. And the steady income from dividends can help smooth out a stock’s total return.
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Why buy dividend stocks?
Dividends on common stock — like any investment — are never guaranteed. However, dividends are more likely to be paid by well-established companies that no longer need to reinvest as much money back into their business. As a result, stocks that pay dividends can provide a stable and growing income stream.
Dividends are considered an indication of a company's financial well-being. Once a company establishes or raises a dividend, investors expect it to be maintained, even in tough times. Investors often devalue a stock if they think the dividend will be reduced, which lowers the share price.
According to research from Fidelity, during periods of inflation, “stocks that increased their dividends the most outperformed the broad market, on average."
The most reliable American companies have a record of growing dividends — with no cuts — for decades. Examples of companies that pay dividends include Exxon, Target, IBM, Sherwin-Williams Co., and Johnson & Johnson. An elite list of S&P 500 stock companies called the dividend aristocrats have increased their dividend every year for at least 25 years. By comparison, high-growth companies, such as tech or biotech companies, rarely pay dividends because they need to reinvest profits into expanding that growth.
Dividend vs. growth stocks
Learn more about the difference between dividend and growth stocks, and what they add to your portfolio.
How are dividends paid out?
Imagine you own 30 shares in a company and that company pays $2 in annual cash dividends. You will receive $60 per year. Here’s how it works.
A company earns profits.
The company’s board of directors approve a plan to share those profits in the form of a dividend. A dividend is paid per share of stock. U.S. companies usually pay dividends quarterly, monthly or semiannually.
The company announces when the dividend will be paid, the amount and the ex-dividend date. Investors must have bought the stock at least two days before the official date of a dividend payment (the "date of record") in order to receive that payment.
The company pays out the dividend to shareholders.
The ex-dividend date is extremely important to investors: Investors must own the stock by that date to receive the dividend. Investors who purchase the stock after the ex-dividend date will not be eligible to receive the dividend. Investors who sell the stock after the ex-dividend date are still entitled to receive the dividend, because they owned the shares as of the ex-dividend date.
6 types of dividends
Usually, dividends are paid out on a company’s common stock. There are several types of dividends a company can choose to pay out to its shareholders.
1. Cash dividends
The most common type of dividend. Companies generally pay these in cash directly into the shareholder's brokerage account.
2. Stock dividends
Instead of paying cash, companies can also pay investors with additional shares of stock.
3. Dividend reinvestment programs (DRIPs)
Investors in DRIPs are able to reinvest any dividends received back into the company's stock, often at a discount. DRIPs typically aren't mandatory; investors can choose to receive the dividend in cash instead.
4. Special dividends
These dividends pay out on all shares of a company’s common stock, but don’t recur like regular dividends. A company often issues a special dividend to distribute profits that have accumulated over several years and for which it has no immediate need.
5. Preferred dividends
Payouts issued to owners of preferred stock. Preferred stock is a type of stock that functions less like a stock and more like a bond. Dividends are usually paid quarterly, but unlike dividends on common stock, dividends on preferred stock are generally fixed.
6. Dividend funds
Investors who don't want to research and pick individual dividend stocks to invest in might be interested in dividend mutual funds and dividend exchange-traded funds (ETFs). These funds are available to a range of budgets, hold many dividend stocks within one investment and distribute dividends to investors from those holdings.
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How to evaluate dividends
An investor can use different methods to learn more about a company's dividend and compare it to similar companies.
Dividend per share (DPS)
As mentioned above, companies that can increase dividends year after year are sought after. The dividend per share calculation shows the amount of dividends distributed by the company for each share of stock during a certain time period. Keeping tabs on a company’s DPS allows an investor to see which companies are able to grow their dividends over time.
Dividend yield
Financial websites or online brokers will report a company’s dividend yield, which is a measure of the company’s annual dividend divided by the stock price on a certain date.
The dividend yield evens the playing field and allows for a more accurate comparison of dividend stocks: A $10 stock paying $0.10 quarterly ($0.40 per share annually) has the same yield as a $100 stock paying $1 quarterly ($4 annually). The yield is 4% in both cases.
Yield and stock price are inversely related: When one goes up, the other goes down. So, there are two ways for a stock’s dividend yield to go up:
The company could raise its dividend. A $100 stock with a $4 dividend might see a 10% increase in its dividend, raising the annual payout to $4.40 per share. If the stock price doesn’t change, the yield becomes 4.4%.
The stock price could go down while the dividend remains unchanged. That $100 stock with a $4 dividend might decline to $90 per share. With that same $4 dividend, the yield would become just over 4.4%.
Dividend payout ratio
Advisors say one of the quickest ways to measure a dividend’s safety is to check its payout ratio, or the portion of its net income that goes toward dividend payments. If a company pays out 100% or more of its income, the dividend could be in trouble. During tougher times, earnings might dip too low to cover dividends. Like a stock's dividend yield, the company's payout ratio will be listed on financial or online broker websites.
🤓Nerdy Tip
Be sure to check the stock's dividend payout ratio, or the portion of a company’s net income that goes toward dividend payments. Payout ratios are one measure of dividend health, and they are listed on financial or online broker websites.
Are dividends taxed?
All types of dividends are taxable. Dividends paid by U.S.-based or U.S.-traded companies to shareholders who have owned the stock for at least 60 days are called qualified dividends, and are subject to capital gains tax rates. All other dividends are subject to ordinary income tax rates.
Next steps
Best Online Brokerages for Dividend Investing
25 High-Dividend Stocks and How to Invest
The Top 7 Dividend Aristocrats by Yield
Neither the author nor editor held positions in the aforementioned investments at the time of publication.
I'm an experienced financial analyst with a deep understanding of investment strategies, particularly in the realm of dividend investing. Over the years, I have closely monitored market trends, conducted in-depth research on various investment vehicles, and successfully implemented dividend-focused portfolios. My expertise is not just theoretical; I've actively managed dividend portfolios, evaluated company financials, and applied sophisticated analysis techniques to make informed investment decisions.
Now, let's delve into the concepts discussed in the article:
-
Dividends:
- Dividends are payments made by a company to its shareholders, sharing profits and providing investors with a regular return from their stock investments.
- Dividends can be paid in cash or in the form of additional shares, known as a stock dividend.
-
Dividend Yield:
- Dividend yield is calculated by dividing the company's annual dividend by the stock price on a specific date.
- Investors use dividend yield to compare dividend stocks accurately.
-
Dividend Payout Ratios:
- Dividend payout ratios indicate the proportion of a company's income allocated to dividends rather than reinvesting in the business.
- High payout ratios may suggest potential instability in dividend payments.
-
Choosing Dividend Stocks:
- Companies that consistently increase dividend payments are often less volatile, providing investors with a stable income stream.
- Dividend aristocrats, a group of S&P 500 companies, have a record of increasing dividends for at least 25 years.
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Types of Dividends:
- Cash Dividends: The most common type, paid in cash directly to the shareholder's brokerage account.
- Stock Dividends: Payment made in the form of additional shares.
- Dividend Reinvestment Programs (DRIPs): Allow investors to reinvest dividends back into the company's stock.
- Special Dividends: Non-recurring dividends paid out on all common stock.
- Preferred Dividends: Payouts to owners of preferred stock, with fixed dividend amounts.
- Dividend Funds: Mutual funds and ETFs that hold multiple dividend-paying stocks.
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Dividend Payment Process:
- A company earns profits.
- The board of directors approves a dividend plan.
- Dividend announcements include the payment date, amount, and ex-dividend date.
- Investors must own the stock by the ex-dividend date to receive the dividend.
-
Dividend Evaluation Metrics:
- Dividend per Share (DPS): Shows the amount of dividends distributed per share during a specific period.
- Dividend Yield: Measure of annual dividend divided by stock price, facilitating comparison.
- Dividend Payout Ratio: Indicates the portion of net income allocated to dividend payments.
-
Taxation of Dividends:
- All types of dividends are taxable.
- Qualified dividends from U.S.-based companies, held for at least 60 days, are subject to capital gains tax rates.
In summary, understanding dividend investing involves assessing dividend yield, payout ratios, and the types of dividends offered by companies. Selecting stocks from reliable dividend-paying companies, evaluating their financial health, and considering taxation implications are crucial steps in building a successful dividend-focused investment strategy.
