What Are Dividends? How Does It Work?

While investing in stocks has proven to be the easiest and best way for the average investor to build long-term wealth, owning stocks that pay dividends is an often-overlooked way to help achieve that goal. A dividend is a distribution of a portion of a company’s earnings. Knowing how dividends work, you can own these types of stocks to your long-term advantage. Here’s what you need to know about dividend-paying stocks.

What are dividends?

Companies regularly pay a dividend to their shareholders. A dividend is the portion of a company’s earnings that it pays to its shareholders. A company’s dividend strategy is generally determined by its financial strategy. Dividend payouts can range from a high percentage of a company’s earnings to a low percentage of its earnings. A company that typically pays out a high percentage of its earnings as dividends have a “high yield.” For example, if a company’s regular quarterly dividend is $0.30 per share, then it will pay out $30 per share in dividend payments. That’s a payout ratio of more than 50%. That means that the company will be paying $30 per share in dividend payments each quarter.

How do dividends work?

In a nutshell, the primary benefit of owning dividend-paying stocks is a payout of a portion of a company’s earnings. Typically, the distribution that you receive is determined based on certain metrics, including the earnings per share, the total earnings, the free cash flow, the earnings on ordinary activities, the cash available for distribution, and the total return on the stock, among other things. Dividend payments are determined by factors including the company’s earnings, how much it pays out on common and preferred shares, and how much it returns to shareholders. For a company’s common shares, earnings-per-share, or EPS, is the simplest calculation to determine the amount of money it is paying out on dividends.

Importance of dividend

Dividends are often used as a way to help investors secure income by having their investments return money to them on a monthly or quarterly basis. More and more, it’s not just retirees who are relying on dividends to help pay their living expenses, as roughly half of the S&P 500’s constituents pay some type of dividend. Dividends are different from interest, which is the income a bank or other financial institution earns by lending money to customers or other clients. A dividend does not depend on the company’s ability to pay interest, which means they are not subject to the same interest-rate risk that money-market funds are. Dividends are also seen as a safety net.

Types of dividends

There are two primary types of dividends: regular and special. Regular dividends are given out as a set amount every quarter based on the company’s profits. That amount, known as the dividend payout ratio, is calculated by dividing the quarterly dividend payment by the company’s profits for the prior fiscal year. In a special dividend, the company does not pay out its normal dividends and pays the dividend out in a one-time way. The one-time dividend can be a certain amount of money or a share of the company’s stock. In the most common cause, the company will pay a one-time dividend because of a certain event that caused the company’s profits to rise substantially.

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How often are dividends paid?

Companies that have been in business for a minimum of a decade are required to distribute a certain percentage of their earnings to shareholders. This requirement isn’t adjusted, as some firms have chosen to discontinue payments. But for those who have been in business for more than a decade, this requirement is annually and is set at a minimum rate. For many companies, the distribution of earnings will occur in the following calendar year. But many companies use their free cash flow, or cash generated by the company’s existing assets and activities, to fund payouts in different quarters. In fact, there’s a difference of more than half a percent between how much a company allocates to capital expenditures and cash payments to shareholders.

Why buy dividend stocks?

When investors buy stocks that pay dividends, they’re typically paying an investor that owns the stock a portion of the profits. While there’s nothing wrong with investing in a stock that doesn’t pay a dividend, doing so can make the stock less volatile and cheaper to own over time. Keep in mind that stock price fluctuations occur due to a multitude of factors. Some of these changes are due to changes in the price of the stock itself, such as when a company increases or decreases the price it is willing to sell the stock for. Other factors, like the economic and political environment, have a big impact on stock prices. While these factors can move stocks around in the short term, dividends can give you a predictable cash flow.

How to evaluate dividends

The first thing you need to know is that dividends are paid on an ongoing basis. A company doesn’t have to declare a dividend each quarter. Instead, it can do so when it issues a quarterly dividend, quarterly dividend payout ratio, quarterly dividend amount, etc. Another factor to keep in mind is that dividend payouts are subject to the company’s dividend policy. What this means is that the company’s board of directors has to set a target amount that it will pay out each year in relation to earnings, and that payout is typically expected to be equal to or higher than earnings. Several companies across different industries pay dividends that are significantly above average, while some pay below-average dividends.

How to choose the right dividend stock to invest in

The first thing you should consider when looking to buy a dividend stock is whether the payout is well covered by earnings. Simply put, a payout ratio is the percentage of a company’s earnings that it allocates to dividends. A high payout ratio is one that indicates a company has a lot of cash available for dividends and might have more options for paying dividends in the future. In a bull market, a payout ratio below 80% or even 50% is a good indicator that the stock’s dividend yield is going to be higher than what investors will receive from a 1% rise in the company’s annual dividend.

How much to invest in dividend stocks?

You need to decide how much money you want to allocate to the stock, and then how much you want to receive as a dividend. Dividends are payments that typically comprise one-third to one-half of a company’s annual net income, so dividend yield is a pretty good proxy for the dividend yield. With many dividend-paying stocks, you’ll earn more money if you hold them for a long time. But how much money? Generally, a stock with a regular dividend payout will produce a higher dividend yield (the number of income investors receives for their investment) than a stock that doesn’t pay a dividend. In fact, even a company with a fairly modest dividend yield may still offer you a potentially higher total return than other stocks. On the flip side, investing in stocks that pay no dividends can be a good way to gain long-term wealth. Think of it this way: If you know a dividend stock is a good investment, then the percentage you pay for that stock will be a meaningful part of your long-term capital gains.

Conclusion

In the simplest sense, dividends are nothing more than the earnings that a company pays out in cash every quarter, year after year. Dividend payments are typically tied to the performance of the stock, but that does not have to be the case. If you own dividend-paying stocks, you receive the same cash each quarter based on a predetermined formula that takes into account how the company performed but doesn’t require you to buy the stock at a particular price. How does it benefit me? For the most part, dividends are widely accepted by most investors. Yet, this could be the one aspect of investing that they overlook. Why? If you know nothing else about dividend stocks, you know that they often go up and down and can even take a big drop if a company has poor performance.

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NB: The purpose of this website is to provide a general understanding of personal finance, basic financial concepts, and information. It’s not intended to advise on tax, insurance, investment, or any product and service. Since each of us has our own unique situation, you should have all the appropriate information to understand and make the right decision to fit with your needs and your financial goals. I hope that you will succeed in building your financial future.