Here we discuss what dividends are and how they work so you can make informed decisions when investing in dividend paying stocks. As a company, regular dividend payments create an incentive for shareholders to remain invested and keep the business growing, while for investors a dividend payment can increase the overall ROI and provide additional income streams. Learn the difference between stock dividends and cash dividends below.
What is a dividend?
Dividends are a way for companies to share their profits with shareholders. When a company earns profits, it can choose to distribute those profits back to its shareholders in the form of dividends. Dividend payments are typically made in cash and are usually paid out every quarter or semi-annually. Dividend paying companies can also choose to pay stock dividends, which is essentially dividend income paid out in shares.
By investing in dividend paying stocks, investors have the potential to earn regular income from their investments as well as benefit from capital appreciation when stock prices rise.
Dividend paying stock and the stock exchange
Investors in the stock market can earn returns in two ways, one is through an increase in the stock price from when they purchased it, and the other is through dividends. A company can decide whether they pay out dividends or not, and it's worth noting that not every company on the stock market does pay out dividends. The ones that do are typically mature ones.
Companies might instead decide to use the profits to reinvest in the company, hire new employees, or expand their business. Start-ups and newer companies are more likely to take this approach as their goals are more aligned with growth.
These payments are made in cash and generally occur at regular intervals, be it quarterly or annually. The amount per share, and when and how often dividends are paid out are determined by the company's board of directors.
Why a company might pay dividends
When a company is profitable, it might do one of these three things with its profits:
- pay off debt
- chase a growth opportunity by reinvesting the money into the business
- pay dividends to their shareholders, attracting new ones and rewarding current ones
Companies pay dividends to reward their shareholders, generating a steady income stream, and increasing the overall value of their stock. Additionally, dividend payments can be used to attract new investors and signal financial strength. Only profitable companies will pay out dividends, and typically ones without significant debt.
Stocks that pay dividends
Whether a company pays dividends is directly related to its goals and priorities. As mentioned above, younger companies typically use profits to reinvest in the business as the current goal is growth, while more mature, established companies opt to reward (and attract) shareholders.
Companies looking to capitalize on growth opportunities might make the wiser move by reinvesting their earnings instead of offering dividends to shareholders.
Let's use retail as an example. If a company has just released a new product, it'd likely benefit more from hiring additional salespeople who can promote it than partaking in payouts for investors. In doing so, this allows the business to seek out maximum returns and drive the stock price up instead of giving away potential gains prematurely.
As companies reach their peak and shift to a sustaining stage, they are more likely to prioritize dividend payments for shareholders over investing any additional funds into growth.
Ultimately, leaders must determine what is best for the company's shareholders depending on its size and age: paying dividends, funding development opportunities, or debt reduction. The ideal choice depends heavily upon the organization’s state of expansion as well as other considerations.
Mutual funds and ETFs
Investors in mutual funds and exchange-traded funds can also tap into dividend income provided that the stocks pay dividends. These are typically paid out on an annual basis, however, this will be determined by the shareholder's brokerage account.
Timeline of dividend payouts
Whether a company pays out dividends at regular intervals or on a once-off basis, below are several dates to note with regard to the when and how of these payments. From the declaration date to the ex-dividend date to the payment date, these all play an important role for investors looking to benefit from dividend yield.
- The Declaration Date
When the Board of Directors announces the value, record date, and payment date for the upcoming dividend.
- Ex-Dividend Date
The ex-dividend date is the final date by which you can buy the stock and earn dividends. If you purchase stock after the ex-dividend date you are not liable to receive dividends. Stock purchases can sometimes take two days to clear so ensure that you do so at the right time.
- Record Date
The date that you need to be an official shareholder in order to receive dividends. If your stock purchase is not settled by this date you are not liable for the payouts. The record date is typically one date after the ex-dividend date.
- Payment Date
When payments are made to all registered shareholders (as of the record date). Depending on the preferences specified in your brokerage account, the dividend could either be credited to you as cash (cash dividends) or reinvested back into the issuing business, distributed as stock dividends.
How dividend payments can affect the share price
Due to dividends being paid out by profitable businesses, when a business does pay out dividends this sends a signal to the market that the business is doing well and could drive the stock price up. However, it could have the opposite effect too, driving the price down when there is no dividend payout.
- when dividends drive the stock price up
Dividends can be a celebration of a company's profits and act as rewards to shareholders for investing in the company. This makes the stock more attractive to investors looking to earn passive income and will ultimately drive the price up.
- when dividends drive the stock price down
Companies generally pay dividends only when they are assured that the rate of return can be sustained, thanks to reliable profits. Therefore, if a company announces any reduction in this rate of dividend payment, it is likely because their business is encountering certain difficulties, sending out a negative signal instead.
In conclusion: what is a dividend payment?
A dividend is a payment that companies make to their shareholders, usually in the form of cash or stock. It's a type of reward for investors who have held onto the company's shares for a certain period of time. Usually companies pay dividends on a quarterly basis, often based on a portion of the company’s profits.
Because dividends are usually paid in cash, they can be a great source of income for investors. This extra income comes with less risk than other types of investing, which makes them attractive to many people who are looking for reliable returns on their investments. Dividend stocks also tend to outperform the overall stock market.
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