Wondering What Are Dividends?
What are dividends in stocks?
How does it work?
In this article, I will break down the question What Are Dividends so you know all there is to know about it!
Keep reading as I have gathered exactly the information that you need!
Let me explain to you the meaning of dividends and why it’s so important!
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What Are Dividends
Dividends refer to distributions corporations make of their profit to their shareholders.
In other words, investors who purchase shares of a dividend-paying stock expect to receive a regular distribution of cash paid by the company out of its retained earnings.
Although most dividend payments are made in cash, a dividend can also be paid to shareholders in the form of stock (this is called a stock dividend).
A cash dividend is when the payment is paid in “cash” whereas a stock dividend is when the company issues additional shares of stock to the shareholder representing the value of the dividends.
Companies that pay dividends tend to pay at a regular interval like monthly, quarterly, or yearly (quarterly being the most common payment frequency).
However, if a company pays a one-time dividend, we call that non-recurring dividend as a special dividend.
There are many companies out there that do not pay dividends to their shareholders as the company board considers that reinvesting its profits back into the business or paying off debt will bring more value to the shareholders.
On the other hand, other publicly listed corporations tend to regularly pay dividends to their shareholders signaling that they are financially strong, well-established in their industry, and capable of growing the business while paying dividends to their shareholders at the same time.
What is the definition of a dividend?
According to Investopedia, a dividend is defined as:
A dividend is a distribution of cash or stock to a class of shareholders in a company.
The “cash” comes from the company’s net income or its retained earnings.
The shareholders of the company are typically common shareholders or holders of preferred stock.
The company is generally a corporation listed in a stock exchange that is well established generating consistent returns.
What are the different dates related to dividend payments?
There are four important dates related to dividends:
- Dividend announcement date
- Ex-dividend date
- Dividend record date
- Dividend payment date
The dividend announcement date (or dividend declaration date) is when the board of directors formally announces that the company will pay dividends subject to the approval of the shareholders.
The ex-dividend date refers to the date as of which a new shareholder will not be entitled to receive the next dividend payment (to be entitled to receive dividends, you’ll need to buy the stock before the ex-dividend date).
The dividend record date refers to the cutoff date where shareholders of record will be eligible to receive dividends based on the number of shares they held on the record date.
Finally, the dividend payment date refers to the day the company is expected to actually pay dividends to its shareholders.
Why Dividends Are Important
Dividends are important in many ways.
For companies, paying dividends allows them to signal to the market that they are:
- Financially stable
- Have strong earnings
- Can generate profits
- They can generate recurring revenues
Companies pay dividends to reward their shareholders for investing in their company.
When companies pay dividends, shareholders and the market generally see that as a positive signal allowing the company to keep investor trust.
For the investors, investing in the best high dividend stocks or other securities that pay dividends is a great way to earn an income while holding on to their investment.
Some investors are looking to complement their income by receiving dividends while other investors are looking to invest in dividend paying stocks to reinvest the dividends going forward.
When a company has a long history of paying dividends, can sustainably pay dividends and continue to grow its business, many investors will see benefits in investing in that company to earn dividend income and for the potential of capital appreciation on their investment over time.
Dividend Investing Metrics
There are a few important metrics to consider when investing in stocks for dividends:
- Dividend yield
- Dividends per share
- Dividend payout ratio
- Earnings per share
The dividend yield represents the percentage cash return you are expected to receive by investing in the stock.
For example, if the stock price per share is $100 paying out a dividend of $4 per year on a per-share basis, your dividend yield is 4%.
The dividend per share is a common metric that indicates how much dividends the stock pays per share (for instance $4 per share per year).
The dividend payout ratio is the percentage of the company’s profits that are paid out to shareholders.
Finally, the earnings per share refers to how much the company has earned in revenues on a per-share basis.
Dividend Yield Meaning
One of the most popular and commonly referred to dividend metric is the dividend yield.
The dividend yield is the ratio between the company’s cash dividend payment distributed to its shareholders in relation to the value of the stock.
The higher the dividend yield, the more you’ll receive in cash dividends for every stock purchased.
For example, if you are looking to purchase shares of stock at $100 per share paying $5 of dividends per year, the dividend yield is 5%.
Getting a high dividend yield, at first glance, appears to be a good thing.
However, you should be careful as in some cases the dividend yield artificially goes up when the stock is not performing well and its stock price is declining in value.
How Dividends Work
A dividend is a distribution of profits by a company to its shareholders.
The most common type of dividend payment is the cash dividend.
When a company pays its shareholders cash dividends, it is taking cash from its retained earnings or net profits and pays its shareholders.
In general, for a company to pay dividends, the dividend payment must be approved by the shareholders through their voting rights and the board of directors.
When the dividend is declared, the company will set the dividend amount, payment frequency, dividend record date, and dividend payment date.
As you know, companies need capital to operate their business.
As a result, in most cases, corporations do not pay dividends to their shareholders so that they can keep 100% of their net profits to inject back into the business, pay off debt, or fund the expansion of the business operations.
On the other hand, there are companies that generate enough returns that they can afford to take a portion of their net income and distribute it to their shareholders in the form of dividends rewarding them for their investment.
You have to keep in mind that not all companies paying dividends are necessarily profitable or represent safe investments.
In certain cases, a company may pay dividends to its shareholders just to maintain its track record of paying dividends even though they may be operating at a loss.
In other cases, a company may only want to get rid of funds available in its retained earnings as a means to defend itself from a hostile takeover.
Special dividends are dividends that are paid to the shareholders on a one-time basis.
Imagine a special dividend to be like a bonus payment issued to the shareholders by the corporation.
A company that typically does not pay dividends may decide to make a one-time payment of dividends to its shareholders to distribute accumulated cash.
Alternatively, a company that regularly pays dividends to shareholders may also choose to pay a special dividend if they had a great year generating a lot of profits (for example, in 2004 Microsoft paid a special dividend of $3 per share to its shareholders).
Stock dividends are dividends that are paid to shareholders in the form of stocks (instead of cash).
When a company issues additional shares in lieu of cash dividends to compensate the shareholders, the shareholders will end up with additional shares in their portfolio.
Some shareholders may choose to sell the stock dividend to realize the cash value whereas other shareholders may keep the stocks in their portfolio.
What Types of Securities Pay Dividends
What are the different types of stocks and securities that pay dividends?
Dividends on Common Shares
Fundamentally, companies are not obligated to pay dividends to their common shareholders.
However, if the board of directors determines that the company will pay dividends to a certain class of stock, then the shareholders will receive a “dividend” payment as determined by the board.
When the board “declares” a dividend, it will set the amount of dividend per share, the record date, and the payment date.
Dividends on Preferred Shares
Other types of shares, such as preferred shares, may entitle their shareholders to dividend payments for so long as the preferred shares are outstanding.
In essence, in some cases, companies issue dividend payment preferred shares obligating the corporation to pay dividends as per the rights and privileges granted to the preferred shareholder.
As such, some investors will invest in the purchase of preferred shares as they know that the company must pay them dividends over time.
Dividends on Mutual Funds And ETFs
In addition to common shares and preferred shares, other types of securities can also pay dividends.
There are mutual funds and exchange-traded funds that are specifically designed to pay dividends to their shareholders.
Mutual funds and ETFs can invest and hold different types of securities.
Those that invest in quality dividend-paying stocks will receive dividends and then pass on the dividends to the mutual fund or ETF holders.
Dividends on REITs and MLPs
You’ll find real estate investment trusts (REITs) and master limited partnerships (MLPs) that are types of securities that pay dividends to their shareholders.
Real estate investment trusts are legally required to pay 90% of their taxable income in the form of dividends where 20% of the dividends must be paid in cash.
In other words, REITs are top dividend payers as they are required by law to pay dividends to maintain their legal classification as a REIT giving them tax advantages.
Other Types of Dividends
There are different types of dividends that can be paid to shareholders in addition to cash or stock dividends.
A company may choose to pay an asset to shareholder in the form of a dividend (asset dividend).
An asset can be a physical property, real estate, investment in securities, or other types of assets.
In addition, a company can also pay other types of securities as dividends such as options, warrants, or shares of a spin-off company.
What Are The Best Dividend Paying Stocks
What are the types of companies that are the best dividend paying companies out there?
The best dividend paying stocks tend to be companies with the following characteristics:
- They are larger corporations
- Well-established in their industry or sector
- Have predictable profits year-over-year
- Have reached a maturity stage
As an investor, you’ll notice that companies operating in the oil and gas, banking and financial, healthcare, pharmaceuticals, utilities, and basic materials tend to pay dividends.
You’ll notice that companies do not pay dividends or very low dividend yields to shareholders when they operate in the technology space or biotechnology.
These companies operate in industries that require a lot of investment in research and development, innovation, and business growth leading their board of directors to favor retaining all their earnings to reinvest back into the business than to pay dividends.
What Are Examples of Dividends
Let’s look at a couple of examples of dividends to better illustrate the point.
Example of High Dividend Stocks
A high dividend-paying stock is a relative concept as it depends on the investor and the stock that you are considering to buy.
A lot of investors like to see a high distribution of cash on their investment and so they tend to favor high dividend stocks.
Imagine that a company operates in an industry where on average the dividend-paying companies pay dividends at a yield of 2%.
If a company operating in that industry pays dividends of 3% or 4%, you can consider that it’s a high dividend stock in relation to that industry.
If the company’s share price is $100 per share, a 3% yield means that the company distributes $3 of dividends per year on each of its common stocks ($0.75 per quarter).
Example of Best Dividend Paying Stocks
What is an example of the best dividend paying stock?
The best dividend paying stocks are the ones that have the following features:
- They have a long track record of paying dividends
- They have demonstrated the ability to increase dividends over time
- The company’s revenues have grown over the years
- The company is well-established in its industry or is a leader
- The company has predictable revenues
For example, companies like Coca Cola or 3M are two examples of companies that are considered “dividend aristocrats” as they have a long history of paying dividends to their sharheolders.
Both of these companies are industry leaders and have a strong and healthy financial position allowing them to not only have enough capital to operate their business but also pay dividends to their shareholders.
What Are Dividend Payments Takeaways
So, there you have it folks!
What are dividends in stocks?
What are the distributions to shareholders by a corporation called?
The distributions that corporations make to their shareholders are called “dividends”.
Dividends refer to a payment in cash or stock that corporations make to their shareholders out of their profits or retained earnings.
Dividend investors like to invest in stocks that pay dividends as they can receive a steady stream of income in the form of dividends by holding on to their stock.
Public companies and private corporations can pay dividends to their shareholders.
Corporations typically do not have any legal obligation to pay dividends to their shareholders (although there are exceptions).
Also, holders of different classes of stock may not be entitled to receive dividends in the same way.
For example, preferred shareholders are entitled to receive dividends on their stock whereas common shareholders are not guaranteed to receive any dividends unless the board of directors declares dividends.
In the end, investing in stocks that pay dividends is a great way to earn a passive income while holding on to your investment.
I hope that I was able to explain to you what are dividends, what are stocks with dividends, how dividends work, the type of dividends, and their features.
Good luck in growing your wealth!
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Summary of What Are Dividends In Stocks
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