What Is a Dividend? - MagnifyMoney

What Is a Dividend?

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You’ll love dividends if you loved getting an allowance as a kid.

Dividends are profit-sharing payouts from a company to its shareholders made in cash or additional shares. You can use these payments to generate a steady income stream — likewise, you can also reinvest them back into the stock to increase your holdings and, potentially, your returns.

What is a dividend?

A dividend is a share of a company’s earnings that it gives to investors in the form of cash or more shares of its stock. Think of these payments as a “thank you” from the company for being an investor.

However, these profit-sharing payments aren’t guaranteed. If finances are tight, a company might suspend or cut dividend payments, as some did during the COVID-19 pandemic — just like your parents might have stopped your allowance if one of them lost their job. But since investors take this as a bad sign, companies try to keep up with payments — if only to keep investor sentiment high.

Dividends can also change with company profits. While bonds typically have fixed interest rates throughout the bond’s lifetime, dividend rates can grow over time.

Why do companies pay dividends?

Similar to how a quarterly bonus may attract employees to a company, regular dividends can attract investors to a stock. In addition, investors often view these payouts as a sign of good financial health, as only companies with actual profit can afford to make them.

For example, mature companies are more likely to pay dividends because they’re beyond a growth phase that requires more capital. In contrast, younger companies often reinvest profits into business operations to accelerate goals.

How do dividends work?

Companies pay dividends on a per-share basis. So, as an example, if a company issues a $0.50 per share dividend and you own 20 shares, you’ll receive $10.

Before a company can disburse payments, its board of directors must approve them, as well as the amount. The company will then set the record date, which is the date on which you must own the stock to be able to receive the dividend.

Once the record date is determined, the ex-dividend date is set — the date on which new share purchases are no longer eligible for the dividend. The last date to purchase new shares of the stock and get the payment will typically be the trading day before the ex-dividend date.

Are there different types of dividends?

Companies can pay dividends in different ways and on different schedules, including:

  • Cash dividends made in cash and deposited directly to your brokerage account
  • Stock dividends made as additional shares of the company stock
  • Special dividends made outside of a company’s regular schedule when profits are high
  • Variable dividends made on a regular schedule, but tied to specific performance goals or financial results
  • Preferred stock dividends made to preferred stock shareholders

How often are dividends paid?

In the U.S., most companies pay quarterly dividends, although some may opt for monthly, semiannual or annual payment schedules.

How do you calculate and compare dividends?

There are a few ways to calculate and compare dividends. The most common is the dividend yield, but we’ll also discuss dividend payout ratio and dividend per share (DPS).

Dividend yield

Dividend yield tells you the dividend-based return you’re making on your investment. You can calculate using the following formula:

Total annual dividend payment / price per share = dividend yield

For example, if you owned shares of a company that paid a $0.50 dividend four times per year, the annual dividend would be $2.00. If the company’s stock trades at $100 on the day you calculate its dividend yield:

$2.00 / $100 = 0.02 which is 2% yield

Remember that your dividend yield will fluctuate based on the dividend amount and a stock’s share price on the day it’s calculated. For instance, if the above stock’s share price dips to $75 because of recession news, the dividend yield would increase to 2.6%. While a minor increase, it’s likely not representative of a stock’s historical yield.

Dividend payout ratio (DPR)

To avoid choosing a stock based solely on its high dividend yield — which could be unsustainable — is to look at its dividend payout ratio (DPR).

This ratio shows how much of the company’s income it pays out to shareholders, calculated as:

Total dividends / net income = DPR

For example, if the company above trading at $100 had a net income of $100,000 and paid out $15,000 in dividends, its DPR is 15%.

To better understand how sustainable a company’s DPR is, you can review its annual reports for a few different years and calculate the DPR.

Dividend per share (DPS)

DPS is simply a company’s profit-sharing payout per share. This calculation is beneficial if you’re investing in dividend stocks for income. DPS helps you determine how much income you’ll receive for each share you own.

You can find the DPS for stocks you own in two ways: a formula, or by using online sites that aggregate dividend history.

The formula for DPS is:

Earnings per share (EPS) x Dividend Payout Ratio = DPS

For instance, if the company above had an EPS of $2.50 and a DPR of 15%, the DPS would be $0.375 per share. So if you owned 100 shares of this stock, you’d earn $37.50 per year in dividends.

To find a company’s DPS history online, you can use sites like Nasdaq or Dividend.com.

Why invest in stocks that pay dividends?

Aside from the extra change in your pocket, dividends can play an important role in your wealth-building strategy in three key ways:

  • Extra income. A portfolio with consistent dividend payments during retirement can help you live off your investments — even if stock prices decrease.
  • Compounding returns. Dividend reinvestment plans (DRIPs) turn your dividend payments into additional stock shares to build your position and future dividend payouts over time.
  • Buffering returns in down markets. Even if a company’s share price falls in a bear market or recession, dividends can still generate positive returns.

How do you invest in dividend stocks?

You can invest in dividend stocks individually or through an exchange-traded fund (ETF) or mutual fund.

When investing in individual stocks, research the company’s underlying financials and dividend and stock performances. You can easily find historical dividend performance for companies at sites such as Dividend.com, DividendInvestor.com or Nasdaq.

A dividend ETF or mutual fund could be a great option if you’re less confident in your ability to analyze and monitor company financials. With dividend funds, you get instant diversification, so If one company cuts its dividend, you’ll still receive dividends from others in the fund’s portfolio.

If you want a bit of help building a dividend-savvy portfolio for retirement, you can always talk to a financial advisor. An advisor can help you create an income plan and even build a portfolio that maximizes income while decreasing risk exposure. A simple conversation can keep this “allowance for adults” from passing you by — especially in the years you’ve more than earned it.

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Frequently asked questions

A stock dividend is a profit-sharing payment made to shareholders as additional or fractional stock shares.

While there’s no specific sector that’s a lock for high dividend payments, the stocks that pay the highest dividends are typically stocks that consistently raise their dividend payouts over time. To help identify these companies, you can begin your research with the S&P 500 Dividend Aristocrats. This index lists companies in the broader index that have raised dividend payouts for a minimum of 25 consecutive years.

In short, no. While some companies choose to redistribute a portion of profits to shareholders, others might choose to keep the cash — called retained earnings — to reinvest into the company.

The “Find a Financial Advisor” links contained in this article will direct you to webpages devoted to MagnifyMoney Advisor (“MMA”). After completing a brief questionnaire, you will be matched with certain financial advisers who participate in MMA’s referral program, which may or may not include the investment advisers discussed.