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How do dividends work?

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When a company becomes profitable, it can either reinvest its earnings into the business or return the earnings to investors as a reward. A dividend is the portion of a company’s earnings returned to investors as a cash payment directly into their accounts.
When you invest in a company’s stock, you effectively own a tiny fraction of the company. Depending on the type of shares you own, you may also have certain rights, such as access to investor calls, ability to vote in corporate elections and the right to receive dividends. However, some companies don’t pay dividends to investors.

How do dividends work?

Dividends are typically distributed to investors quarterly, though some companies pay out dividends monthly or yearly. The amount you receive depends on the number of shares you own. A company’s board of directors convenes regularly to decide if a dividend will be paid out and how large it will be.
For example, Merck & Co., Inc. (MRK) paid a quarterly dividend of $0.69 for each share held on March 14, 2022. If you owned 1,000 shares, you would have received a dividend of $690. In May 2021, however, when Organon & Co. was spun out of Merck, Merck issued a special one-time dividend one-tenth of a share of Organon common stock for every Merck common share. It’s unlikely that investors will once again receive Organon stock as a special dividend.

Pros of dividends

  • Greater stability. Dividends can be a more predictable source of income in an otherwise volatile, unpredictable stock market.
  • Tax treatment. In countries or circumstances where dividends enjoy tax-free status, investors benefit from receiving dividends over a proportionate growth in share prices.

Cons of dividends

  • Unnecessary pressure. Some companies might be better off reinvesting their earnings into the business, but the fear of losing shareholders might drive the company to retain dividends.
  • High-yield dividend traps. Some companies entice unwitting investors with dividend yields north of 10%. Yet, these companies are unlikely to continue paying such exorbitant dividends in the long term.
  • Limited earnings. Stocks that yield dividends tend to generate lower returns than higher-risk investments, such as options and crypto investments.

4 types of dividends

Regular, quarterly cash dividends are the most common type, but some companies utilize other forms of dividends. Note that most companies will only issue one or two types and don’t typically employ them all.

  1. Regular dividend. Get cash or stock directly in your trading account. Regular dividends are common amongst most public companies.
  2. Special dividends. These are unscheduled, one-time payments declared due to a special corporate event, like a spin-off or a sudden influx of cash.
  3. Variable dividends. Most companies pay out the same exact dividend every quarter. Variable dividends take into account changes in the company’s earnings by tacking on a percentage of the previous quarter’s earnings.
  4. Preferred dividends. A preferred dividend is specifically paid out to a company’s preferred shareholders. These are investors that hold a special class of shares that allow first dibs on a company’s dividends.

3 ways dividends are paid out

Contrary to popular opinion, dividends are not always paid out as cash.

  1. Cash dividends. As the most common type of dividend, cash dividends are paid directly to your trading account.
  2. Stock dividends. A company could also choose to pay out dividends as stock. These shares are added to your existing share count.
  3. Dividend reinvestment programs (DRIPs). DRIPs are reinvestment programs offered by brokerages to turn cash dividends into stock dividends. If you would like all your dividends as shares, you can elect your broker to automatically buy shares at the market price once your dividends are issued as cash.

How to evaluate dividends

How do you decide if a dividend payout is a good deal?
First, if a company pays out a regular dividend, consider if the company should even be paying out that dividend or if it’s returning a sufficient amount of cash to shareholders. Perhaps it should be paying out much more, or it should be reinvesting that cash into growing the business. Dividend investors often look for a sustainable dividend ratio even if there is no benchmark for a good dividend ratio.
If a payout ratio is too high, it could also mean that the deal is too good to be true. A good yardstick is to compare the company’s dividend to that of others in the same industry or sector. A sudden cut in dividends could indicate that the company’s prospects or trajectory has changed significantly.

When are dividends paid?

Dividends are usually announced during a company’s quarterly earnings calls when its management provides an update on the business. From there, a sequence of events follows that determines how the dividends are paid out.

  1. Announcement date. On the announcement date, the company’s management will declare that a dividend will be paid out at some point.
  2. Ex-dividend date: The ex-dividend date is the date by which investors must own the stock to qualify for the dividend. If you only own the shares on the ex-dividend date or any day after, you will not be entitled to this round of dividend payouts.
  3. Record date. By this date, the company must determine which investors will receive a dividend and in what order.
  4. Payment date. The dividend is finally paid out. Depending on your trading platform, it might take one or two business days for the dividend to reach your account.

Why do companies pay dividends?

Once a business matures, it may become profitable and earn more than it spends maintaining the business. As the company’s cash pile grows, it has a couple of options: reinvest the cash into growing the business, buy shares back to reduce the outstanding amount or issue dividends.
Share buybacks have become popular recently as a way to indirectly reward shareholders without redistributing cash back to shareholders. If a company doesn’t require the cash to execute a merger or grow its business, it can choose to share the profits with investors through a dividend. Dividends can be an alluring reward for investors, especially those who depend on their investment portfolio to bring in a consistent income.

Dividend aristocrats

Dividend aristocrats are S&P 500 companies with a history of 25 years’ worth of dividend increases. Not only have these companies paid dividends for nearly three decades, but they’ve also raised their dividends consistently in that time.
If that criteria wasn’t stringent enough, each of these 65 dividend aristocrats must be worth at least $3 billion with a daily trading volume of at least $5 million. Some of the most popular dividend aristocrats include:

  • Johnson & Johnson (NYSE:JNJ)
  • The Coca-Cola Company (NYSE:KO)
  • Walgreens Boots Alliance, Inc. (NASDAQ:WBA)
  • Chevron Corporation (NYSE:CVX)
  • International Business Machines (NYSE: IBM)
  • 3M (NYSE:MMM)
  • Nucor Corporation (NYSE: NUE)

Impact of dividends on stock prices

When dividends are paid out, they are paid out of the company’s cash balance, making the company technically “worth less” once dividends are paid out. In some cases, stock prices are likely to decline on the ex-dividend date.
Let’s say a company’s ex-dividend date is April 2, and they’ve declared a $2 dividend per share. If it is currently trading at $100 on April 1, it might begin the trading session the next day at $98, automatically adjusting for the dividend that has been paid out. Although this isn’t a hard-and-fast rule, the price might correct to reflect the right value of the company post-dividend.

How are dividends taxed?

Since the IRS considers dividend payments a form of income, you must report dividends as taxable income when you file your tax return. How much you’re going to be paying depends on a few questions and considerations:

  • Are your earned dividends flowing through a tax-advantaged account? If you’re receiving a dividend into a 401K or a Roth IRA, those dividends won’t be taxed.
  • Is it a qualified dividend? Qualified dividends are issued by US companies or foreign American Depository Receipts listed on US exchanges. If you’ve held the shares for more than 60 days, these dividends will be taxed as long-term capital gains anywhere from 0 to 20%. Non-qualified dividends are taxed anywhere from 10% to 37% as they’re treated as short-term capital gains.
  • What’s your tax bracket? If you’re single and earned $40,000 for the filing year, you’ll be in the 0% tax bracket for long-term capital gains and 12% for short-term capital gains.

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Bottom line

Dividends are a way of rewarding investors, and some dividend-issuing companies remain among the best investments on the stock market today. While dividend stocks typically underperform riskier investments, they offer relatively stable returns and could be used to diversify your portfolio. Get started with dividend investing today by comparing the top stock trading platforms.

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