Dividends are disbursements of a company’s earnings paid to the shareholders of the company. Dividends are typically paid directly in cash and on a quarterly basis (every 3 months).
Investors view dividend payments as profit sharing. Dividend-paying companies have strong, continuous profits and want to provide value back to their investors. This is usually a cash payment, but sometimes a company may issue stock as payment instead.
In either case, the company rewards its shareholders continuously with profits from the business for being investors.
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Understanding Dividends
A company’s governing board of directors determines if a dividend will be distributed. In fact, most companies do not pay a dividend at all. Instead, most will retain all the profits and either hold on to the cash or reinvest it into the company.
Here’s how it works:
Let’s say you own 1,000 shares of ROBO Inc. ROBO Inc. has had a continuous streak of earnings and is ready to start paying dividends. So it announces a $2.50 dividend. This means you will get a deposit of $2,500 (1,000 * $2.50) into your brokerage account as your portion of the dividends. There are specific time periods in which you must own the stock to be eligible for dividend payouts. See below for more specifics.
The dividend yield is the amount of dividend paid versus the price of each share. This is expressed as a percentage. For example, if the share price is $50 and the dividend payment is $2.50, this equates to a 5.0% yield ($2.50 / $50). Setting the share price aside – the 5% yield will continue to provide you a 5% cash stream as long as the dividend stays the same.
Why Do Only Some Companies Pay Dividends?
Mature Cash Flowing Businesses
Companies go through early stages of accelerated growth, and if they’re lucky enough to survive the gauntlet, they become mature cash-flowing businesses. This may take years or even decades. Eventually, a company will reach a point where investments in the growth of the existing business are no longer feasible. This is where management must make the tough decision of pivoting the company and trying new things or focusing on driving value to the shareholders.
Cash-generating companies are highly attractive to investors, but investors also want a sense of security that the company will bring value to shareholders. This can be in the form of cash dividends and/or stock buybacks.
A company in the position to continue to grow its revenue and cash flows while driving direct value to shareholders will attract many investors. Apple (AAPL) is a perfect example of this.
In 2012, Tim Cook became CEO of Apple, and he had to fill the shoes of Steve Jobs – one of the greatest innovators of the last 100 years. Tim knew that he wasn’t the innovator that Jobs was and had to make some changes to reassure investors. The following year he started a stock dividend program that was well received by investors and has continued to reward investors.
Reward Shareholder Continuously
Introducing a continuous dividend program can be risky for a company. Investors view dividend programs as something that should continue and grow indefinitely. Thus, if a company cannot commit to such a plan, it is a huge risk to existing shareholders.
Paying dividends results in removing cash from the company’s retained earnings that it will no longer have access to. This means that it will have less of a safety net in the event of an economic downturn.
Ideally, investors want to see sustained revenue growth and a sustained or growing dividend. If either of these is to decline, the market will typically sell down the price of the shares in fear the company can’t maintain this program. If a company were to eliminate its dividend program, it would likely lose many investors.
Once a dividend program has been set forth, it should be continued. If the company can both grow its earnings and support a dividend-paying program, it will be rewarded by attracting long-term institutional investors.
When Are Dividends Paid?
The most common dividend payment frequency is every quarter (3 months) or 4 times yearly. For example, Apple, Microsoft (MSFT), Wal-Mart (WMT), Verizon (VZ), and Chevron (CVX) all pay a quarterly dividend – four times per year. Other periods of dividend distribution include monthly and yearly.
Hundreds of companies offer dividend distributions at varying intervals and yields (% returns).
On rare occasions, a company may decide to issue a one-time large dividend. These are called special dividends. It usually only takes place when a company has had stronger-than-expected earnings. Special dividends may be taxed slightly differently than planned dividends. See the section on dividend taxes.
Do ETFs Pay Dividends?
Yes, any dividend that is paid by a company within an ETF is given to the ETF’s shareholder. This is a requirement for ETFs.
Remember, an ETF is a basket of stocks trading as a fund. Many ETFs hold stocks that are dividend-paying companies. Thus, all the dividends paid to the ETF are distributed to the shareholders of that ETF. This is the case for cash and stock-paying dividends.
How Dividends Are Taxed
Cash dividends do carry tax implications with them. The great news is that long-term holders have reduced tax rates. The rates are 20%, 15%, or 0%, and are taxed at the same rate as long-term capital gains. The difference between stock sales and dividend payments is that you don’t have to hold the stock for 1 year to be eligible for lower tax rates.
According to the IRS, you must own the stock for 60 consecutive days before the ex-dividend date. The date you purchased the shares does not count toward the 60 days. The ex-dividend date is typically the day before the record date. You must own the stock before the ex-dividend date to be eligible to receive the dividend payment.
Here’s how it works – in 4 chronological steps.
(1) The company will have a dividend declaration date. This is the date it announces it will pay $XX.XX dividends.
(2) Ex-dividend date – You must be a shareholder BEFORE this date in order to receive the declared dividend.
(3) Record date – This is typically 1 business day after the ex-dividend date. This is the date the company records the shareholders that will receive the dividend.
(4) Payment date – this is the date the company pays the dividend to all of the shareholders that were recorded as shareholders on the prior record date.
Nasdaq.com is a great resource for checking company dividends.
If you are a long-term investor in dividend-paying companies, you don’t need to worry about dividend dates. You can sit back and collect your dividends without worrying about ‘if’ you qualify to receive dividends and ‘how much taxes’ you will owe.
Special Cases of Dividends that Involve Capital Gains
On rare occasions, a company may declare a dividend and include in the dividend declaration that it is a ‘return of capital.’ When this happens, the portions considered a ‘return of capital’ will reduce your cost basis of the stock. This will result in more capital gains taxes when you sell the shares, but not until then.
Example: You purchase shares of XYZ Co. for $50.00 per share – your cost basis is $50.00.
XYZ Co. declared a $3.00 special dividend; $ 2.00 is considered a return of capital, and the remaining $1.00 is the standard taxable dividend.
The result is a new cost basis of $48.00. ($50.00 – $2.00 return of capital)
As I said, this is a rare occasion and usually only happens when a company has a large amount of excess cash and wants to return it to shareholders.
Dividend Reinvestment Plans (DRIP)
A dividend reinvestment plan is an option offered by most companies for its shareholders to receive additional shares of the company rather than cash payments. These shares are automatically purchased directly from the company rather than through the broker. This comes at no additional cost to the shareholder.
Don’t think that you can avoid taxes, though. DRIP plans still require you to pay taxes on the dollar equivalent of the shares you received.
This is a great option for passive long-term investors that want to continue investing in the same company. Some companies even offer stock purchases at slightly discounted prices, so you could get even more for your money.
Nearly every online broker has the option to reinvest dividends. Check in the settings of your brokerage account to find out how to activate this option if you’re interested.
Conclusion
Receiving continuous payouts on your investments is a wonderful thing. However, when purchasing dividend-paying stocks, you should know what the stock’s fair value is before purchasing. This way, you can purchase the stock at a fair price that can offer you a dividend yield that fits your investment needs.
Finding companies with a sustainable dividend policy is critical to the stock’s long-term value and ensuring consistent or growing dividend payments. This requires a resilient business model that can continue to provide steady streams of growing cash flow. Find companies that have continued dividend growth and growing cash flows.
There are many ETF options for investors not interested in purchasing dividend-specific stocks. For example, some ETFs hold only dividend companies, and others, like an S&P 500 tracking ETF hold several companies that pay dividends. In either scenario, the dividend will be paid directly to you, the shareholder.
Dividends provide reduced taxed amounts as long as you meet the holding period criteria of 60 days. Dividends are taxed at the same rate as long-term capital gains as long as the holding period is met. This can be a great incentive for many investors who seek tax-beneficial investments.
Acquiring dividend-paying stocks requires the same research as any other stock. Simply purchasing a stock because it pays a dividend is not a smart way to invest. Like any other investment, take the time to understand what you are purchasing and ensure that it fits into your investment goals and objectives.
Frequently Asked Questions – FAQ
What are dividends?
Dividends are payments made by a company from its earnings to its shareholders. They’re typically paid in cash on a quarterly basis, though some companies may choose to issue additional shares as dividends.
Why do only some companies pay dividends?
Dividends are often paid by mature, cash-flowing businesses. Younger or growth-focused companies may prefer to reinvest their earnings into business expansion instead. A company must be confident in its ability to continuously generate profits before it can commit to a regular dividend payout.
How are dividends determined?
Dividends are determined by a company’s board of directors and can vary in amount. A common way to compare dividends across companies is by calculating the dividend yield, which is the amount of dividend paid divided by the price of each share, expressed as a percentage.
When are dividends paid?
Dividends are most commonly paid quarterly, or four times a year. Some companies may pay dividends monthly or annually, and in rare cases, a special one-time dividend may be issued.
Do ETFs pay dividends?
Yes, any dividends paid by a company within an ETF are passed on to the ETF’s shareholders. ETFs are funds composed of multiple stocks, including dividend-paying ones.
How are dividends taxed?
Dividends are subject to tax. However, long-term holders can benefit from reduced tax rates, the same as those for long-term capital gains. The specific rate depends on various factors, but it can be 20%, 15%, or 0%.
What are Dividend Reinvestment Plans (DRIP)?
DRIPs are options offered by most companies that allow shareholders to receive additional shares instead of cash dividends. These shares are purchased directly from the company, often at no extra cost. It’s a popular choice among long-term investors.
What is the ex-dividend date?
The ex-dividend date is the date by which an investor needs to own a stock in order to be eligible for the next round of dividend payments. It’s typically one business day before the record date, which is when the company records which shareholders are due to receive dividends.
Are dividends always a good thing?
While dividends can provide a steady stream of income, investing in a company just because it pays dividends can be risky. It’s crucial to thoroughly research the company and ensure its business model is sustainable, its revenues are growing, and it fits within your broader investment strategy.