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The Dividend

In many countries, companies aim to steadily increase their dividends whenever possible. A drop in dividend payments can result in a very negative reaction from shareholders. Some companies have historically retained their earnings, thereby increasing the absolute value of share prices compared to those companies that have historically paid the majority of earnings/profits in the form of dividends.

 

When a company experiences declining earnings but either maintains or increases its dividends, the dividends are not fully covered by the earnings earned and are known as uncovered dividends.

 

Corporations pay dividends out of their earnings, which are technically called distributable reserves. These are the after-tax profits made over the life of a company, beyond dividends paid.

There are three main types of dividends:

 

  1. Decent dividends. This is by far the most common type of dividend. Regular dividends are paid in cash, most often quarterly, but sometimes semi-annually or annually.

  2. stock dividends. Companies that want to save money can pay dividends in the form of shares.

  3. Hybrid and Real Estate Dividends. These are unusual. A hybrid dividend is a combination of cash and stock, while a real estate dividend is just that -- corporate property or assets that have monetary value.

Companies can also pay what's called a special dividend if they have an unusually profitable quarter or year. This is an additional dividend of additional cash or stock over and above the company's current or regular dividend.

 

Who receives the dividend?

 

When a company declares that it will pay a dividend - typically every quarter, as noted above - the company also provides a record date. The dividend will be paid to anyone who is on record that day as the owner of the company's shares. In most countries, including the US, registration is automatic and requires no special action when purchasing a stock.


The record date has important implications for buyers and sellers of a company's stock as it determines the ex-dividend date. If you buy a stock on or after the ex-dividend date, you won't receive the most recently declared dividend. You buy the stock at or without a dividend. To compensate buyers, the stock price is typically reduced by the amount of the dividend on the ex-dividend date. In the US, as of September 2017, the ex-dividend date is one business (i.e. trading) day prior to the record date.


On the other side of the coin, if you sell a stock but want to receive the dividend, you have to wait until the ex-dividend date to sell your shares. If you sell before the ex-dividend date, you also sell the right to receive the dividend.


In summary, these are the key dates associated with a dividend:

 

Declaration date

 

The day the company announces its intention to pay a dividend.

Recording date

 

Shareholders who are registered owners of the company's shares on that date will receive the dividend.


Ex-Dividend-Date

 

Shares purchased on or after this date will not entitle the purchaser to receive the most recently declared dividend. In the US, this is one business day before the record date.


Date of payment

 

The date on which the dividend is actually paid to the holders of record of a share.


Both common and preferred stockholders can receive a dividend, but the dividend for a stock's preferred stock is usually higher, often significantly.


When you buy and sell stocks through a broker, dividend payments are almost always deposited directly into your brokerage account. Otherwise, a check for the amount of the dividend payment will be mailed to you on payday.

 

Why are dividends important to investors?

 

Investors looking for income are often drawn to companies that pay dividends. They may be more interested in regular dividend payments than stock price performance, or they may want to combine the benefits of regular income with the potential for stock price appreciation. Dividend income also cushions the blow when a stock's price falls.


Similarly, when interest rates are low, investors can reallocate their funds from interest-bearing assets to more productive dividend-paying stocks.


A company's dividend policy and history can also give you important clues about the company. Dividend payments are generally considered a sign of an established company with good financial health and future earnings potential. On the other hand, paying dividends can mean a company has relatively modest growth prospects -- it can be taken as evidence that the company can't use its earnings more productively. For this reason, young, fast-growing companies usually do not pay dividends. They believe they can generate a better return for shareholders by reinvesting all of their profits into their continued growth. How these factors may affect an individual investor's decisions will depend on that individual's investment objectives.


It can also be an important signal when a company that has regularly paid dividends cuts the dividend. This could indicate financial difficulties.


Of course, dividends are also a component of an investor's total return, especially for investors with a buy-and-hold strategy. For some stocks, dividends can account for a significant percentage, or even a majority, of total returns over a period of time.


It can also be an important signal when a company that has regularly paid dividends cuts the dividend. This could indicate financial difficulties.

How are dividend yields measured?

Dividend yield is the annual return an investor receives in the form of dividend payments, expressed as a percentage of the stock's share price. It's an easy way to compare the dividend amounts paid by different stocks. It's calculated by dividing the annual dividend per share by the price per share, and then converting the result into a percentage.


Dividend yield should never be the only factor an investor considers when deciding whether to buy a stock. But income investors tend to prefer higher dividend yields, all else being equal. However, high dividend yields can be a sign that a stock has recently suffered a sharp drop in price, and as such can be a red flag in some cases.


Many income investors also look for a consistent history of dividend payments, preferring companies whose dividend payments have increased (or at least stayed constant) over time with no missed quarters.

 

What is the dividend payout ratio?

 

A second metric, called the dividend payout ratio, is viewed by many investors as an indicator of a company's ability to continue paying dividends at the current rate. Essentially, this metric tells you how much of a company's earnings it pays out each year in the form of dividends. It can be calculated on an aggregate basis or per share.


A payout ratio above 100% would mean the company is paying out more dividends than it earns, which isn't sustainable over the long term.


Dividend payout ratios can vary widely based on various factors. As mentioned earlier, early stage, growth-oriented companies can have zero or very low payout ratios, while more established companies often have higher payout ratios. There are also differences between industries and sectors, so this ratio is most useful when comparing companies within a specific industry.

Should dividends be reinvested?

 

As with other forms of income, what you do with dividend income is up to you. You can use it to subsidize expenses, for example, or to accumulate cash in your brokerage account. Many investors prefer to use it to automatically buy additional shares or units (in the case of mutual funds and some other investments) in the security from which they originate.


This option is often referred to as a dividend reinvestment program, or "DRIP." Originally created by publicly traded companies with direct stock purchase plans, DRIPs are now commonly understood as all types of programs - including those offered by brokerage firms - that facilitate the automatic reinvestment of dividend income.

 

DRIPs offer investors several significant advantages, including:

 

  • Convenience. DRIPS can help you automatically build a larger position in a security over time. On the day of the dividend payment, new shares are purchased with the proceeds from the dividend.

  • cost effectiveness. In most cases, DRIP purchases are free of commissions and other fees, making them a cost-effective option for growing your investments.

  • Flexibility. DRIP purchases can often be made in partial accounts. For example, if you received a $50 dividend from a company whose stock is currently trading at $100, the DRIP would buy half a share on your behalf.

A small caveat: Since dividends are considered income, they generate a tax liability on taxable accounts (e.g. traditional brokerage accounts). This is the case regardless of whether the dividends are paid, saved or reinvested through a DRIP.

 

Dividend yield

 

Meaning: For stocks that pay an annual dividend, this indicates how much a company pays out in dividends relative to the share price. Dividends are not guaranteed - companies may suspend dividends during times of financial difficulty.


Why It Matters: This percentage can help investors gauge how much cash flow they're getting from each dollar invested in a dividend stock. The higher the yield, the higher the dividend yield.


Good to know: In general, stocks with lower growth potential pay higher dividends, while stocks with high growth potential don't pay dividends (the appeal of these stocks is usually the potential for share price appreciation).


While there are many other indicators that can be considered when evaluating a company's overall financial picture, these fundamentals are an excellent place to start.

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