What Are Dividends?

What Are Dividends?

Dividends are a portion of a company’s earnings that is returned to shareholders.  When a public company is profitable, they primarily have seven methods to invest their profits:

1.     Hire new employees

2.     Pay existing employees a higher salary

3.     Purchase equipment and/or services

4.     Merge or acquire another company

5.     Purchase stock shares on the open market (otherwise known stock buyback)

6.     Distribute the profit to shareholders (otherwise known as dividends)

7.     Do nothing and save it for a rainy day.

This article discusses primarily number six.

Why Do Companies Pay a Dividend?

It can be said based upon the other options available the company can/should invest in other more profitable endeavors.  The argument is they are offering a dividend because they cannot put the money to better use within the company.  Some investors see dividends in this fashion, while others view it differently.  Other investors view dividends as a method they have a guaranteed return with their stock ownership.  After all, with a stock with no dividend you are hoping for stock appreciation.  If the stock does not increase in price, or worse loses value, your investment is not profitable.

Stock dividends ensure you see a return from your investment. It is also argued that option number five (stock buyback) is a more tax efficient than dividends as less shares are on the open market.  This means the price of the stock will increase without any tax payment due by the shareholder.  While this may be true, it still does not ensure payment.  In addition, if a stock is owned within a tax differed retirement account, taxes are not a concern.  Hence it’s best to own dividend stocks within these types of accounts.  Currently dividends are also taxed favorably with the extension of the Bush tax cuts.  There is also some evidence stock buyback usually occur when the stock is highly priced, diminishing it’s effectiveness.

A stock with a dividend can be thought of having a stock and a bond component.  So you not own the stock for growth, but also get annual return like a bond.  Dividends provide an added incentive (in the form of a return on your investment) to own stock in stable companies even if they are not experiencing much growth.  Many companies — mature and young, large and small — pay a regular dividend to their stockholders.  Usually stocks that offer dividends are not high-tech, and in high growth sectors.  Though this is changing with companies like Microsoft (MSFT) and it’s been rumored Cisco (CSCO) will soon start offering a dividend.

Dividend Dates

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Dividends must be (approved) by a company’s Board of Directors each time they are paid out.  There are five important dates during a year to remember.

  • Declaration Date
  • In-Dividend Date
  • Ex-Dividend Date
  • Book Closure Date

Declaration Date

This is the day the Board of Directors announces its intention to pay a dividend.  On this day, a liability is created and the company records that liability on its books; it now owes money to its stockholders.  On the declaration date, the Board will also announce a date of record and a payment date.

In-Dividend Date

This is the last day, where the stock includes a dividend.  In addition, anyone selling the stock before this date loses his or her right to the dividend.  After this date the stock becomes ex dividend.

Ex-Dividend Date

This is the day in which shares bought or sold no longer have a right to be paid the most recent dividend.  Existing stockholders will receive the dividend even if they now sell the stock, whereas anyone who now buys the stock will not receive the dividend.  It is common for a stock’s price to decrease on the ex-dividend date by the amount in close proximity to the amount paid in dividends.  This is because a decrease in assets (cash) owned by the company in order to pay the dividend.

Record Date

Whenever a company announces a dividend payout, it also announces a date on which the company will ideally temporarily close its books for fresh transfers of stock.  Record date shareholders registered in the stockholders of record on or before the date of record will receive the dividend.  Shareholders who are not registered as of this date will not receive the dividend.  Registration is usually automatic for shares purchased before the ex-dividend date.

Payment Date

This is the most important date.  It is the date dividend checks will actually be mailed to the shareholders of a company, or credited to your brokerage account.  If you have this stock within a brokerage account, you usually have the option to reinvest the dividend.  This is to your advantage, since the brokerage usually does not charge a transaction fee for this.

Dividend Aristocrats

There are also a select few dividend stocks that not only have offered dividends for years, but also have increased their dividend on an annual basis.  These are known as Dividend Aristocrats.  Being on this exclusive list means for over 25 years not only have they consistently offered a dividend, but has also increased it annually.  The advantage of owning one of these stocks is over time your dividend return increases.  So while you may start with a small sub 3.0% annual dividend return, it can increase quite quickly if held over a 10, 20 or 30-year time-frame.

Why Own Dividend Stocks?

What are advantages and disadvantages of stock dividends?

Pros

  • Evens out stock price fluctuation. You aren’t only relying upon the stock to increase in value.
  • Can be a regular source of income, and is great for retirees.
  • Companies that offer a history of increasing their dividend offer a way to increase your annual returns without doing anything.

Cons

  • If the stock is within a taxable account you will have to pay annual taxes from dividends paid.
  • As we found out in 2008, dividends can be eliminated or reduced at anytime.  Companies like Pfizer (PFE) and Citibank (C) both had a long history of offering a stable dividend.
  • Just because a company offers a dividend does not mean they have the profits to support keep paying the dividend.
  • Just because a company offers a dividend means they are good company to invest for stock appreciation.
  • As mentioned initially, to pay the dividend the company is taking capital from other possible investments.
This was a guest post from Investor Junkie, which is a personal finance blog that reviews the top brokers, and discusses alternative investments.
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Published or updated April 5, 2013.

Comments

  1. Good overview of the pros and cons of dividends, and thanks for the link.

    RE: “Stock dividends ensure you see a return from your investment.” This is a common belief among inexperienced investors, and it’s dangerous. If a stock pays a 3% dividend but falls in price by 5%, that’s a negative return no matter how good it may feel to get the dividend check in the mail. Stocks are always risky and can always lose money, no matter what the company’s dividend policy.

    • You’re welcome for the mention. Investor Junkie turned me on to your series about dividend myths. I think it’s important people know both sides for sure.

    • Hi Canadian,

      You could argue, yes in the short term you have lost money, but it’s only when you sell the stock. This could be akin to current RE investors who own a property that has positive cash flow, but is worth less than the purchase price.

      Also beta for a dividend stock is much lower than a stock without dividends (not a myth :-)) but can’t cite the source on this ATM. So the stock fluctuates less in price since monies taken out from the difference what would be in stock price.

      Yes EVERY investment has risk. Even investments that people consider “risk free”. You must understand what those risks are and some aren’t as apparent as others.

  2. When companies pay dividends they can not reinvest those funds into growth. You are right, this is a stock with a bond component. The stock will have very limited growth. Are there exceptions? Maybe!

  3. Just out of curiosity, what are your favorite dividend company stocks?

  4. Research will be key when it comes to investing in these kinds of stocks. You can learn about such in general at http://www.mutualfundstore.com/investment-planning/about-shares-stock-companies-market-cap, but you will have to watch your investments over time just in case there is a downturn. The market cannot be predicted or timed and you have to determine how much risk you feel you can handle.

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