What Is a Dividend?
Dividends are payments from corporate earnings to company shareholders. Dividends are one way for you to receive a return from owned shares. You can think of them as a reward for investing your money with a company.
How Do Dividends Work?
Dividend payments typically take one of two forms:
Cash paid to you (more common)
Additional stocks issued to you (less common, but you can sell and convert to cash)
Companies may also offer dividend reinvestment programs (DRIPs). These programs allow you to reinvest some (or all) of the dividend back into additional shares of the company at a discounted rate.
Note: Not all stocks pay dividends. To get paid dividends, you would need to choose one of the following:
dividend mutual funds (a collection of dividend stocks), or
exchange-traded funds (ETFs) that pay dividends
Who Pays Dividends?
The company board of directors determines the dividend amount and manages these payments. The amount is usually a portion of company earnings. Companies can choose to not pay dividends and instead reinvest the money back into the company. Again, this type of action must be approved by the board.
Most cash dividends in the United States are paid on a quarterly basis while stock dividends are generally paid at infrequent intervals.
Important Dates for Dividends
Before investing, it’s important to know when a company pays dividends. You should be familiar with the following terms:
Dividend Declaration Date
The declaration date is when a company's board of directors declares that a dividend will be paid. Based on the company’s financial performance, the board determines the amount of the dividend and then declares dividend payments to shareholders on record. The board of directors also announces the dividend record date.
Dividend Record Date
The record day is when a company reviews its books to determine its "shareholders on record." Shareholders who hold a particular stock on this date will receive the firm's dividend payment.
After the Record Date has been determined, the stock exchanges or the National Association of Securities Dealers (NASD) assign the ex-dividend date. The ex-dividend date is exactly one trading day before the record date.
This date is crucial to shareholders because it determines whether you are paid or not. If an investor buys a stock before the ex-dividend date, then they will receive the dividend payment. If they purchase the stock on or after the ex-dividend date, then they will not receive the dividend.
Cash Dividend Example
Let's assume you own 100 shares in a Company on the record date. At the end of the quarter, the company will calculate its company earnings. The board of directors then reviews this information and declares a $0.10 dividend per share for the quarter.
This means that you are entitled to $0.10 x 100 shares = $10.
Stock Dividend Example
If a company declares a 10% stock dividend, then every shareholder will receive an additional 10 shares for every 100 shares they own (when dividends are paid). Stock dividends may be issued when a company does not have cash reserves to pay investors or needs to conserve cash for reinvesting, but still wants to maintain the appearance of paying dividends.
In most circumstances, shareholders can usually sell these new stock dividends on the stock exchange and convert it back into cash. However, the amount received for this sale may be higher or lower than an equivalent cash dividend depending on the share price and time of sale.
Why Dividends Are Important
Dividends are important in the investing world for many reasons.
Dividends Provide a Source of Income
Many investors rely on dividend payments as a source of income. This is especially true if you’re retired and hold a portion of your investment portfolio in stocks.
Let’s say the prices of your stocks increase over time. You will be unable to realize these capital gains until you sell your shares. However, if these stocks pay dividends, you will receive a check in the mail (usually four times a year) for your share of each companies' profits.
Dividends Impact Share Price
Dividends take money out of the company which has an impact on the company share price. This typically occurs on the ex-dividend date because share price drops due to shareholder’s now owning the stock from this date forward.
For example, if a stock is trading at $100 and pays a quarterly dividend of $3 per share, then the stock will open on the ex-dividend date at $97.
Dividends Can Build Company Reputation
A stable dividend payout is a sign of business maturity and confidence in cash flow. Once a dividend is established, investors expect that dividend to remain – even in a financial downturn. If dividends are pulled, the number of investors will drop along with the company reputation.
Dividend payments are vital to the relationship between company and investor. During the financial crisis of 2008, we saw General Motors cut their long-running dividends in an effort to avoid bankruptcy. This enraged many former GM employees who lived on dividend payments from the corporation.
Curious about dividend investments now? Read How Do I Start Profiting from Dividends next.