Dividend Investing Basics: What Are Dividend Stocks?
What Are Dividend Stocks?
Despite its popularity, “buy low, sell high” is not the only strategy for investors to earn a good return from the stock market. In particular, some companies also pay dividends.
Dividends are distributions of a company’s profits paid to the company’s shareholders. Collecting these dividends can be a great way for investors to earn a passive income from the volatile stock market.
With the right dividend stocks, there’s little need to check your portfolio constantly. Investors can simply sit back, relax, and enjoy the dividend checks rolling in.
How Dividend Stocks Work
For the most part, dividend-paying companies operate just like non-dividend-paying ones. Both types are trying to make a profit and create value for shareholders.
The difference is that, on a regular basis (usually every quarter), a dividend stock’s board of directors will declare a dividend. And that dividend will be paid to shareholders.
Dividends are not dependent on share price or stock market fluctuations. Hence, they are a safe way to make money from stocks.
To collect dividends, here are a few dates to pay attention to:
- Dividend Declaration Date: This is the day on which a company’s board of directors declares the dividend.
- Dividend Payment Date: This is the day on which a company transfers the dividend payments to shareholders’ accounts.
- Dividend Record Date: This is the day on which a company’s management team determines which shareholders are eligible to receive the declared dividend.
- Ex-Dividend Date: This date is usually one business day prior to the dividend record date. For investors to be eligible for a company’s dividend payment, they must own the stock before the ex-dividend date.
Why Do Companies Pay Dividends?
When companies need money, they can choose either debt financing (such as borrowing from a bank) or equity financing (issuing shares). In debt financing, lenders can earn interest. In equity financing, investors get a claim on the company’s future earnings.
For established, successful businesses, the claim on earnings often translates to a steady stream of dividends.
Put simply, companies pay dividends because they want to return some of their profits to shareholders.
At the same time, companies can also use dividends to reward loyalty and attract new investors, especially investors with a long-term horizon. For people looking to generate income from stocks, dividend-paying companies will be near the top of their watch lists.
Why Companies Don’t Pay Dividends
There are many reasons why companies choose not to pay dividends.
If a company is in its growth stage and needs to reinvest every penny it makes to expand its operations, then there’s not going to be many resources left for a dividend policy.
Of course, as we see today, even some of the most established companies can go without a dividend policy.
In some cases, management believes it’s more worthwhile to pursue a growth project—which could increase the company’s value and ultimately lead to a higher share price—than to pay cash to investors today.
At the same time, companies may choose not to pay dividends to avoid having to cut their payouts down the road.
You see, while there is no guarantee, dividends tend to be sticky—at least in the U.S. stock market. Once a company sets up a dividend policy, the implication is that it will be paying at least this amount going forward.
The reason is simple: if a company has been paying a steady dividend for a while and suddenly slashes its payout, that would cause major investor disappointment.
Due to the sticky nature of dividend payments, companies have to think long and hard before establishing a dividend policy. If they decide to make regular payments to shareholders, chances are that they are confident about making enough recurring profits to cover those dividends year after year.
Therefore, if a company is doing well today but is unsure if it can maintain its profits at the current level, management will likely be very cautious about paying a regular dividend.
Also, if a company just had an extraordinarily good year or came across some windfall gains, it might pay a special dividend (a concept I’ll discuss below) rather than set up a recurring dividend policy.
Types of Dividends: How Dividend Stocks Pay Out
|Type of Dividend||Method of Payment|
|Regular Cash Dividend||Cash|
|Stock Dividend||Shares of the Company|
|Scrip Dividend||Cash or Shares of the Company|
|Property Dividend||Assets of the Company|
Regular Cash Dividends
When we talk about dividend investing, we are usually referring the cash that companies pay out to shareholders on a regular basis. Indeed, cash dividends are the most common type.
When a company pays a cash dividend, shareholders will either get dividend checks in the mail or have the amount directly deposited into their brokerage accounts.
As for frequency, most companies that pay regular dividends distribute on a quarterly basis. However, there are also companies that pay annual dividends, semi-annual dividends, and even monthly dividends.
So, if a company does not want to return cash to investors regularly, does that mean it can’t pay a dividend?
Not really, because they can also pay one-time dividends.
As the name suggests, one-time dividends are not expected to be recurring. They are often referred to as “special dividends.”
When a company has an exceptionally strong quarter and earns more profits than what it usually does, it can pay out that extra profit to shareholders in the form of a special dividend.
I mentioned earlier that dividends tend to be sticky, which is one of the reasons why some companies choose not to have a regular dividend policy. But with special dividend payments, companies can return cash to investors directly without committing to a quarterly dividend schedule.
Still, it should be noted that even companies with regular dividend policies may choose to pay one-time special dividends at some point.
For instance, in May 2017, Costco Wholesale Corporation (NASDAQ:COST) paid a special dividend of $7.00 per share, which was a substantial amount compared to its regular quarterly dividend rate of $0.50 per share at the time. (Source: “Costco Wholesale Corporation Dividend Date & History,” Nasdaq, last accessed November 22, 2018.)
To shareholders of a regular dividend stock, a special dividend serves as a nice bonus.
So, what are stock dividends? Other than giving investors cash, companies can also pay stock dividends. This happens when the dividend is paid in the form of additional shares rather than cash.
Here’s an easy example: when a company decides to pay a 10% stock dividend, each existing investor will get one additional share for every 10 shares they already own.
However, you may have noticed that issuing stock dividends increases the total number of shares outstanding. And since this act does not change the value of the company, the value of existing shares gets diluted.
Back to our example above, suppose the company was trading at $100.00 per share and has one million shares outstanding before the stock dividend (i.e., it had a market value of $100.0 million). After the 10% stock dividend, the total number of shares outstanding would be 1.1 million.
The stock dividend did not change the value of the company. As a result, each share would now have a theoretical value of $90.90 (calculated by dividing $100.0 million by 1.1 million shares).
For income investors, the goal is to earn a steady stream of income. That’s why, generally speaking, I prefer cash dividends to stock dividends.
When a company declares a scrip dividend, it gives investors the option to receive the dividend in the form of additional shares of the company instead of cash. So basically, investors can choose whether they want to collect a cash dividend or a stock dividend.
Another definition of a scrip dividend is a company’s promissory note to pay investors later. When a company does not have enough cash to fund its dividends, it may issue a script dividend.
We don’t come across property dividends very often in today’s market, but it’s worth understanding what they are. When a company pays a property dividend, it distributes some of its assets, rather than cash, to shareholders. The assets being distributed can include inventory, equipment, real estate, or investments held by the company.
What About Fund Dividends?
Other than buying shares of publicly traded companies, stock market investors can also invest in exchange traded funds (ETFs). As the name suggests, ETFs are funds that trade on stock exchanges. Most of them track some sort of a stock index. And to do that, index funds often hold shares of companies that make up the stock indices.
An ETF’s holdings may consist of dividend-paying companies. If that’s the case, the fund would usually hold all of the dividends paid by underlying stocks and then pay them to shareholders on a pro-rata basis—usually every quarter.
There are quite a few ETFs designed specifically for dividend investors who want to earn a steadily increasing stream of income. You can check out our detailed discussion of them here.
Do Dividends Affect Stock Prices?
When I talked about stock dividends earlier, I explained how a higher share count might lead to a drop in per-share value of a company. But what about cash dividends; do they affect share values?
Well, going back to our earlier discussion on dividend dates, we know that if you want to be eligible for a company’s next dividend, you need to own the shares before the ex-dividend date.
That is, if an investor buys a company’s stock on the ex-dividend date, they would not be entitled to the next dividend. Instead, the seller on the ex-dividend date would get a dividend.
Due to the fact that buying on the ex-dividend date won’t get you the dividend from the company, its stock price tends to drop on the ex-dividend date, usually by roughly the amount of the upcoming dividend.
Worth noting is that dividend announcements are generally considered good news, since they represent cash returns from a company to its shareholders.
However, for a company that has been paying regular dividends for a while, the news of a dividend announcement is usually already priced in. That is, we generally won’t see a surge in share price when a company declares a dividend that it has been paying for a long time.
What could lead to a rising share price, though, is a dividend increase announcement.
Like I said, dividends are sticky. So if a company declares a regular dividend that’s substantially higher than its previous one, it could indicate that management is confident about paying this increased amount going forward.
Therefore, a dividend hike could be interpreted as a genuine sign of strength, and investors may cheer on the news.
How Are Dividends Calculated?
Calculating Dividend Yield
To calculate dividend yield, you simply take the company’s annual cash dividend per share and then divide it by its share price.
Let’s take Best Buy Co Inc (NYSE:BBY), which recently declared a dividend, as an example.
On November 21, the company’s board of directors declared a regular quarterly cash dividend of $0.45 per common share to be paid on December 31. So its annual dividend is $1.80 per share ($0.45 × 4 = $1.80). Divide $1.80 by BBY’s current stock price of $62.09 and we get its dividend yield: 2.9%.
Calculating Dividends Received
I should point out that, because the calculation of dividend yield involves using the stock price as the denominator, a company’s yield would change as its stock price fluctuates.
Therefore, if you are already a shareholder and purchased the stock a long time ago, it’s better to take a look at the actual cash payout than the current yield to calculate the dividend amount you will receive.
Again, using the Best Buy example, suppose an investor already owns 1,000 shares of BBY stock. Given the company’s recently declared dividend, the investor can expect to get paid $450.00 on December 31 ($0.45 × 1,000 = $450.00). And if Best Buy continues with its current dividend rate, the investor would collect a total of $1,800 in dividends from the company over a one-year period.
How Much Do Dividend Stocks Pay?
When investors ask how much dividend stocks pay, they can calculate the dividend yield using the method I described earlier.
However, an easier way to get to the answer is to look up the company’s dividend yield on financial web portals such as Google Finance and Yahoo! Finance. These web sites already have yield information available, so investors can instantly see how much money in dividends (in percentage terms) they can expect to collect in a year if they purchase the stock today.
Again, because dividend yield is calculated by dividing the annual cash payout by the stock price, at any given cash payout, the dividend yield moves inversely to the company’s share price. Therefore, if a stock is soaring and its dividend hasn’t changed, its yield will get lower.
The U.S. stock market had quite a rally since the last financial crisis. Due to the impressive bull run for most of the last decade, dividend yields are now subdued. The average dividend yield of all S&P 500 companies stands at less than two percent at the moment. (Source: “S&P 500 Dividend Yield,” Multpl.com, last accessed November 22, 2018.)
Here at Income Investors, we are determined to help you earn higher returns from safe and rising dividend plays. We recently analyzed companies that pay 6.3%, 7.4%, and even 10.3%. Yield-seeking investors should take a look.