What Is A Dividend And How Does It Work?

Many new investors searching for how to make money in the stock market are asking the same question: What is a dividend? This common source of income from investments can be a fantastic way to grow your wealth and your investment portfolio. However, you’ll need to do your research to determine how to take advantage of dividends. Let’s discuss what you should know below.

Dividends At A Glance

While you may think that investors can only realize a profit when they sell their stock, dividends allow them to grow their portfolio while retaining their investment. That’s because dividends give you consistent income from the companies you invest in.

Definition Of Dividends

Dividends are payments made to shareholders of a company as a reward for investing. They are usually paid on a regular schedule from a company’s net profits on a per stock basis. So the more stocks you own, the larger your dividend. However, dividends are not available for every type of stock, so it is essential to do your research to confirm the type you are buying will receive dividends.

How Dividends Work

Dividends can be distributed to shareholders as cash or additional shares of stock. The company’s board of directors will decide when and how to pay the dividend. For example, let’s say you own 40 shares in Company A. Company A’s board can decide that they will pay $3 per stock in annual dividends, giving you $120 per year. However, you probably won’t get all of this money in one lump sum as Company A will most likely decide to spread the payments over every month or every quarter of the year.

Why Dividends Interest Investors

Dividends are attractive to investors primarily because they can be a stable source of income from investments. Instead of having to wait to sell a stock to make money, investors with dividend stocks can count on a consistent income from dividends if they invest in the right companies that pay consistent dividends. They can use the income to increase their savings, or diversify their investment portfolio by buying stocks that don’t pay dividends. Diversification is a great strategy to reduce the risk of losing a significant amount of money if a change in the market affects one of your dividend stocks.

Why Companies Pay Dividends

Companies pay dividends because they are a sign of financial stability and trustworthiness of the company. If a company has the ability to pay dividends, it means that it has profits left over after reinvesting in growing the company. Showing that you can continue operating efficiently and continue growing your stock price while giving away some of your profits to investors is a significant signal that a company is a mature and well-run organization.

Taxes On Dividends

The tax rate on income from dividends depends on how long you have held the stock, your total income and your filing status. If you hold a stock for less than 60 days before the ex-dividend date, or the first business day after the dividend is paid, it is considered nonqualified and taxed along with your regular income. If you hold a stock for more than that 60-day mark, it is considered qualified and able to be taxed at a rate that is usually lower than your regular income tax rate. The tax rate you will pay on qualified dividends is 0%, 15% or 20% depending on your income and filing status.

4 Types Of Dividends

You can receive dividends in multiple ways and at different times.

1. Cash Dividends

Companies pay cash dividends to shareholders based on a predetermined amount set by the board of directors. The specific date that the payment is made is known as the date of payment. This is the most popular type of dividend.

2. Stock Dividends

Instead of cash, companies can pay dividends by giving additional shares of stock to their investors. The payment is based on a percentage of the amount of shares you own in the company. So if a company issues a 5% stock dividend and you own 60 shares, you will receive 3 additional shares of stock.

3. Special Dividends

Special dividends are paid outside of the normal dividend schedule. These special payments are usually connected to a special event that caused the company to have an inflow of cash, such as the sale of a particularly valuable asset. Special dividends are nonrecurring unlike regular dividends which are delivered on a set schedule.

4. Preferred Dividends

Preferred dividends are reserved for a special group of investors who own preferred stock. This upper tier of shareholders typically receives higher dividend rates than shareholders with common stock. If a company is unable to pay their usual standard dividend, a company will give preference to their preferred shareholders by paying preferred dividends.

Dividend Stock Terms To Know

Brokerage account: An investment account that you can use to buy and sell stocks that pay dividends. You can also use it to buy bonds, mutual funds and ETFs.

Ex-dividend date: You will not receive a company’s next dividend payment if you buy the stock after this date.

Dividend payout ratio: The percentage of a company’s net income spent on dividends in total.

Dividends per share (DPS): The total amount a company pays in dividends divided by the number of shares outstanding.

Dividend yield: The total amount a company spends on dividends divided by the company’s stock price.

Payment date: The date that shareholders receive dividend payments.

Record date: The date that a company declares its current shareholders who qualify to receive a dividend.

How To Invest In Dividend Stocks And Grow Your Wealth

There are some key financial indicators to identify when considering investing in dividend stocks.

Compare Dividend Stocks

The first step in managing your portfolio should be to do your research. When it comes to investing in dividend stocks, that means looking at an array of financial sites and online brokers to see what is available on the market.

A company’s performance is a key factor when determining what stock to buy, but that doesn’t mean you should only look at the stock price or typical dividend amount before you make a decision. Below are some critical financial indicators that you should consider when comparing dividend stocks.

Check The DPS

As mentioned above, the DPS is the total amount a company pays in dividends divided by the number of shares outstanding. You can calculate a stock’s DPS by dividing the total amount a company pays in dividends during a period of time, usually a year, by the total number of outstanding shares. This metric can give you direct insight into how much money you could make in a year if you buy the company’s stock. If a company’s DPS shows a history of increasing over time, it is a good sign that the company is in a strong financial position.

Evaluate The Dividend Yields

The dividend yield is an important factor that you can use to determine your return on investment (ROI). As mentioned above, you can calculate dividend yield by dividing the total amount a company spends on dividends by the company’s stock price. Displayed as a percentage, a high dividend yield can be proof of healthy stock performance and a positive ROI. However, it is important to dive deeper if the dividend yield is unusually high for a stock. If the stock price falls suddenly, the dividend yield can increase substantially but would not represent a healthy company.

Weigh The Dividend Payout Ratios

The dividend payout ratio is the percentage of a company’s net income that it spends on dividends. You can calculate the payout ratio by dividing the total amount of dividends paid by the company’s net income. This is a key measurement to determine the maturity of a company.

A newer company typically has to retain a large portion of their net income in order to continue growing their business. A mature company on the other hand may be more willing to pay a higher portion of their earnings toward dividends because they are near the peak of their size and stability. So a high dividend payout ratio can be a good indicator of a mature, stable company to invest in.

Decide How Much To Invest

The financial details of companies, stocks and dividends are not the only thing you should worry about. Your own financial well-being is arguably the most important factor to analyze before investing. Make sure to do a thorough review of your monthly income, expenses, existing debt, and existing investments to determine how much money you can afford to invest in a dividend stock. Once you know how much to invest, also consider where to invest. Diversifying your portfolio by investing in multiple stocks across multiple industries can save you from relying on one risky stock to perform well. It may also help to discuss your unique financial situation with a financial advisor before making investing decisions.

Alternatives To Dividend Stocks

There are several alternatives to dividend stocks that you can invest in to diversify your portfolio. Exchange-traded funds are a pool of securities packaged by investment companies and sold on the open market. ETFs are a great way to diversify your portfolio because diversification is a core part of their structure. If you’d like to continue earning income from your ETFs, you can even focus on buying ETFs made up of a pool of high-dividend securities.

Mutual funds are another option for investors who do not want to spend as much time researching their investments. Mutual funds are managed by financial experts and allow you to pool your money with other investors.

The Bottom Line: Dividends Can Be A Valuable Part Of Your Portfolio

Dividends are a key part of a diversified investment portfolio because they can increase your income without having to sell any of your investments. If you study the financial elements that indicate successful dividend stocks, you can strengthen your portfolio with mature and stable investments. As with any investment, though, nothing is foolproof or completely risk-free. Consult a financial professional for help planning your investing strategy.

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