How Do Dividends Work?

You might already know that you need to diversify your assets through traditional securities such as stocks, ETFs and mutual funds. It’s a good idea to spread your risk through diversification so you can protect your assets from market volatility.

But do you know much about dividends — the hard-won results of your investing efforts? To understand dividends, you must first understand the different types of dividend payments available and how companies pay dividends. Once you have a good basic understanding of these, you can take advantage of the benefits that cash dividends, property dividends, stock dividends, liquidating dividends or a mix of these can have to jazz up your portfolio.

What are Dividends?

Dividends entitle you, the shareholder, to a portion of the net profits made by a company. Dividends are earnings that a company you invest in pays its shareholders, and for every share of a dividend stock that you own, you’re paid a portion of these earnings.

Why Companies Offer Dividends

In corporate finance, dividends occupy a central position, acting as a bridge between a company's profitability and shareholder rewards. As such, dividends serve multiple purposes.

• Investor attraction: Regular dividends can lure income-focused investors, as they provide a steady stream of returns outside of capital appreciation.
• Company signal: A consistent or increasing dividend can indicate a company's financial health and positive outlook, bolstering investor confidence.
• Capital allocation: Rather than reinvest all profits, a company might distribute dividends when it sees limited high-return investment opportunities, ensuring shareholder wealth maximization.

The decision to issue dividends lies with the company's board of directors. For investors, dividends are more than just income; they're a key indicator of a company's fiscal health and its commitment to shareholders.

How Companies Create Dividends

Once the decision has been made, companies that wish to issue dividends will follow these steps:

Step 1: Declaration Date

The declaration date is the day that a board of directors issues a press release stating its intention to pay a dividend. Along with a declaration date, the board also announces the date of record and payment date.

Step 2: Date of Record (Ex-Dividend Date)

The date of record marks when stockholders are entitled to the dividend payment. A stock will usually begin trading ex-dividend or ex-rights the fourth business day before the payment date. Only the owners of the shares on or before that date will receive the dividend income.

Step 3: Payment Date

The payment date is when shareholders actually receive their dividends. As a general rule, most dividends are paid on a quarterly basis, although some companies pay dividends annually. In addition, a company can sometimes declare dividends on a specific class of shares and can pay preferred shareholders or both preferred and common shareholders. A company is not obligated by law to pay out dividends until it has made a formal declaration.

Factors Influencing a Company's Dividend Policy

A company's dividend policy is shaped by various internal and external considerations, representing a blend of its financial health, strategic ambitions and market realities. Here are some critical factors that influence this policy.

• Earnings and profitability: A fundamental determinant, consistent and growing profits provide the necessary funds for dividend distribution. Companies with erratic earnings might adopt a conservative dividend stance.
• Cash flow position: Even profitable companies need sufficient cash flow to cover dividend payments. Strong and predictable cash flows can support regular and increasing dividends.
• Debt levels: Companies with high debt might prefer using profits for debt reduction rather than dividend distribution since servicing debt can be a pressing obligation.
• Retained earnings: If a company foresees potential investment opportunities, it might retain more earnings for future expansion or R&D, limiting the amount available for dividends.
• Business cycle: Companies in growth phases often reinvest profits, while mature companies with steady earnings might distribute higher dividends.
• Tax considerations: The tax treatment of dividends versus capital gains can influence a company's payout decision, given potential tax implications for shareholders.
• Market expectations: Established companies with a history of regular dividends might continue the trend to meet shareholder expectations and maintain investor confidence.

A company's dividend policy is a multifaceted decision that balances its immediate financial situation with long-term growth objectives and shareholder value maximization.

What You Can Gain from Dividends

Dividends, as a method of distributing a portion of a company's earnings to its shareholders, can be issued in various forms, each catering to different corporate needs and shareholder preferences.

• Cash dividends: The most common type, these are direct payments made to shareholders, typically on a per-share basis. The funds are transferred electronically or via checks.
• Stock dividends: Instead of cash, companies distribute additional shares of stock to existing shareholders. This method increases the total number of outstanding shares without immediate cash outflow from the company.
• Property dividends: Less common but still noteworthy, a company might distribute tangible or intangible property as dividends. Examples include real estate, physical assets or shares from a subsidiary.
• Scrip dividends: Companies offer promissory notes for payment at a future date, useful when facing short-term liquidity issues but expecting future cash inflow.
• Special dividends: Issued outside regular payment cycles, these often result from a significant windfall, such as proceeds from an asset sale.
• Liquidating dividends: When a company plans to dissolve or wind up its operations, it might return capital to shareholders as liquidating dividends.

The method chosen reflects a company's financial situation, strategic priorities and approach to shareholder relations. By understanding these different types, investors can better assess the implications of dividend payments on their investments and overall portfolio strategy.

How to Calculate Your Dividend

To calculate your stock’s dividend yield, divide the annual dividend by the stock’s price.

The dividend payout ratio is the percentage of net income paid out as a dividend. The retention ratio (the amount not paid out to shareholders in dividends) is the figure used to project growth. To calculate the payout ratio, divide the total amount of dividends paid out to shareholders by the reported net income of the company.

If you receive dividends from holding stock in a company, keep in mind that as an investor, you’ll face tax implications. Dividends are taxed as ordinary income, which means you’ll have to include the dividend yield on your income tax return. However, if company prices go up, you can sell your stock at a profit and be subject to a long-term capital gains tax.

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The last thing to think about is what to do with your dividends and whether you’ll reinvest them. When you buy shares of a security, your broker asks whether you want dividends reinvested so you can automatically use them to buy more shares of the stocks in your portfolio. The process of doing this is called a dividend reinvestment plan (DRIP). Reinvesting dividends can offer you several benefits:

• You automatically invest more money.
• You don’t pay commission on a DRIP.
• No minimum investment amount has to be met.
• You can buy fractional shares.
• Your investment’s growth compounds because you continually add more shares that also eventually generate dividends of their own.

One more thing to keep in mind is that any dividends that are reinvested in a DRIP are known as qualified dividends. You’ll still pay taxes on them, but they’re taxed at a lower rate than regular income.

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