Stock investors have different goals. Some buy stock so they can sell it high at a profit soon, whereas others buy it so they can get a share of the company’s profits regularly, something called a dividend.
With that brief introduction, we can say that a dividend is simply a regular payment made by a company to shareholders (owners of the company’s stock). Companies pay dividends to shareholders as a way of distributing revenue back to investors.
It is important to understand that not all stocks pay dividends so investors interested in getting a return on their investment in stocks through dividends should opt for buying dividend stocks.
Now that you know what a dividend is, let us move on to knowing how they work, and how companies calculate how much to pay out and when.
How do stock dividends work?
Most times when we hear we brace ourselves for long technical explanations that sometimes leave us more confused but you are in luck because I am not like those people. I will make this as simple for you as possible.
A dividend is paid per share of stock. For example, if you own 100 shares in a company and it pays $4 annually, your total dividends will be $400 per year.
This can be paid in cash to your brokerage account or the company may offer you a dividend reinvestment program (DRIP) where you can reinvest your dividend back into the company by getting more stock at a discount. The choice is yours. See? I told you it would be simple.
Now, let us move on to when companies pay dividends.
In previous articles, I have highlighted the fact that companies release quarterly performance reports where they tell their shareholders and the public at large things like their balance sheet, income statement, statement of cash inflows among others. This is when most companies pay out dividends to their shareholders.
Alternatively, some companies pay out dividends monthly or semi-annually. For a company to pay out dividends, each dividend has to first be approved by the company’s Board of Directors. This approval is followed by an announcement of when the dividend will be paid, how much, and the ex-dividend date.
You must own the stock before the ex-dividend date so you can qualify to receive the dividend. Just to throw some light on the ex-dividend terminology, because, well, I am making things easy for you, the stock begins to trade without the subsequent dividend value on this day. If you buy stock on or after this day, you will not be eligible to get a dividend. Interestingly, the seller is still eligible for a dividend on that stock because they owned it before its ex-dividend day.
For investors that do not have the time to follow this little but important detail yet they want to earn dividends on their stocks, please opt for investing in mutual funds and Exchange-Traded Funds (EFTs) which hold numerous dividend stocks as one investment on behalf of other investors. When the EFT gets dividends on their investment, it distributes them to its investors. Think about this like putting your money in NSSF. NSSF invests it for you in different stocks and then pays you a sum every quarter on that investment.
A company’s stock yield is a measure of the company’s annual dividend divided by its stock price on a certain date. A dividend yield evens the stock market playing field and allows for a more accurate comparison of dividend stocks.
For example, if a company prices its stock at $10 and pays a dividend of $0.40 per share annually, its yield is the same as that company whose stock price is $100 paying $4 annually. The yield is 4% in both cases.
The dividend yield is inversely related to the stock price, meaning that when one goes up, the other goes down. Company’s dividend yield can go up in two ways.
- If a company raises its dividend but its stock price stays the same, its dividend yield will rise.
- If a company’s stock price goes down but its dividend stays the same, its dividend yield will rise as well.
Analysts say that 4% is the standard dividend yield for most stocks and so those that have a higher percentage are seen as unsustainable, so investors should be careful with them.
However, stocks that were created to pay dividends like Real Estate Investment Trusts (REIT) have an exception for this 4% dividend yield rule, as they can pay dividend yields ranging from 5% to 6% and still have potential to grow.
Companies’ dividend yields are listed on financial and online broker websites.
Dividend payout ratio
Apart from calculating how much you will be paid on your stock payment and when you should look out for the company’s payout ratio. This is the portion of the company’s net income that is spent on dividend payments.
Analysts say it is safe to invest in stocks whose dividend pay-out ratio is 80% or below to be on a safe side. Companies which payout 100% of their net income in dividends are thought to be in trouble or something.
Types of dividends
In the first article I published here that acted as the beginner’s guide for stock investment, I briefly talked about the types of stock, but not the types of dividends specifically. If you read it, you remember, if you did not, do not worry, it is my job, literally, to remind you.
To be fair, the type of stock you take up pretty much defines the type of dividend you will be paid.
For those that invest in common stock, your dividends will not come regularly, but a company will distribute profits earned over a period of time, could be years, to its common stockholders. You might not get recurring dividends if you own common stock but the upside of it is that you have voting rights when the company is making decisions.
The other type of stock is the preferred stock, which is, as it says in the word, preferred to common stock because owners get a recurring fixed dividend usually quarterly.
Companies that pay dividends on their stock are those that have already established themselves so there is little to no need to reinvest their income or profits in things like expansion.
This is in contrast to high-growth companies, mostly those in tech who reinvest their profits to facilitate their expansion and growth.