What are Dividends?

Dividend paying stocks can be a great way to earn income through equity investing. Here is a look at what are dividends.

What are Dividends

When companies make money, they typically reinvest some of the cash back into the company and pay a remainder of the cash to the shareholders as dividends. So, a dividend is a payment that a corporation makes to its shareholders.

Dividends are usually paid on a quarterly basis, but companies may have special one-time dividends when an investment is liquidated or a business is sold. Otherwise, you’ll receive a quarterly check with your dividend payment. You can often choose to receive a cash payout of your dividends or have them reinvested. Reinvesting allows you to increase your stock holdings without putting more of your own cash into the stock.

Not all companies pay dividends. For example, new companies typically don’t pay dividends. You’re more likely to receive dividend payments from an older company that’s more established. Just because a company doesn’t pay dividends doesn’t mean you can’t make money from investing in that stock. Instead, you’d make money from trading the stock when share prices exceed your purchase price. Stock prices rise when the market decides the company is more valuable for example because that company has increased its profits or otherwise expanded its business.

Important Dividend Dates

The board of directors decides when to pay a dividend and how much to pay. Then, the company announces their intent to pay dividends on the declaration date. The date of record, or ex-dividend date, is the date by which stocks have to be purchased to receive dividends. Any stock that’s purchased after the date of record won’t receive the previously declared dividend. Finally, the payment date is the date the dividend is actually paid to the shareholder.

Taxation of Dividends

Even though the company has paid taxes on profits when they were earned, the dividend recipient also has to pay a capital gains tax on qualified dividends. The amount of the dividend tax depends on how long you’ve held the investment.

Measures to Evaluate Dividend-Paying Stocks

The dividend yield is a financial ratio that indicates the amount of dividends a company pays out compared to stock price. You can calculate it by dividing the amount of dividends per share by the price per share. For example, if you bought shares of a stock for $30 each and the company pays $2 dividend per share each year, the yield is 6.67%. Generally, you’d prefer the stock from a company with a higher dividend yield, but that doesn’t mean the company is performing better. The company might not be able to maintain high dividend yields for a long period of time. The company will either have to lower its dividends or make more profits to stay in business.

Dividend payout ratio is another that you might use to choose a dividend-paying stock. It’s the percentage of earnings that are paid as dividends. It’s calculated by dividing annual dividends by earnings per share. (Earnings per share is equal to net earnings divided by the number of outstanding shares.) Mature companies usually have higher dividend payout ratios. However, a ratio that’s too high might be unsustainable.

While the debt/equity ratio doesn’t directly indicate dividend performance, it does indicate a company’s financial health and likelihood of paying dividends. The debt/equity ratio is total liabilities divided by shareholders equity. It indicates the amount of debt the company has. Since bondholders get paid before shareholders, a high debt/equity ratio could indicate a company’s future trouble in paying dividends.

There may be times when the company suspends their dividends. This might happen if the company is in financial trouble. Even when shareholders don’t get their dividends, bond holders receive their coupon payments, unless the company is in really bad shape. Preferred stock holders, who don’t get to vote for the board of directors, receive their dividends first. And if the company foresees financial trouble, they may suspend dividend payments to common stockholders while continuing payments to preferred stock holders.