How Do Dividends Work and What Does Dividend Mean?

Posted at Aug. 4, 2022, 8 p.m.

Looking to grow your wealth and generate income from dividend stocks but don't know what a dividend is? Here's everything you need to know about dividends, including the definition of a dividend in simple terms anyone can understand.

What Is a Dividend and What are Dividend Stocks?

A dividend is a distribution of a company's earnings to a class of its shareholders. Dividends can be awarded in the form of cash payments, shares of stock, or other property. They are typically paid quarterly. Sometimes you will register also an annual dividend or more frequently dividend paid. For publicly traded companies, the dividend is often determined by the board of directors and approved by the shareholders. Private companies may distribute dividends at the discretion of the company's owners. Dividends are typically taxable as income for shareholders, but there may be special circumstances where they are treated as capital gains. 

Dividends are one way that companies can return value to shareholders. They provide income for investors and can also signal confidence in the company's prospects. While dividends are not required, they are often seen as a sign of a well-run and profitable business. Many investors seek out companies that pay dividends as a way to generate reliable income from their portfolios. Dividends can also help to support the share price of a company during periods of market turbulence. For these reasons, dividends have long been an important part of the investing landscape.

Why Do Companies Pay Dividends?

Dividends are a way for companies to share their profits with shareholders. By paying dividends, companies can generate passive income for shareholders, which can help to increase shareholder value. Dividends can also help to attract new investors, as they provide a tangible return on investment. Finally, dividends can help to improve a company's financial performance by reducing its tax liability. As a result, dividends are an important tool for companies to use to improve their financial position.

Which dividend terms and components are important to know?

What is a company's board?

The board of directors is a group of individuals responsible for the oversight of a company's operations. The board typically approves the dividends distributed amount and schedule.

What is a preferred dividend?

Preferred stock dividends are dividends that are paid on shares of preferred stock and are a type of stock that has preference over common stock with respect to the payment of dividends and the repayment of capital if a company is liquidated. While dividends on preferred stock are typically fixed, dividends on common stock may be increased, decreased, or eliminated at the discretion of the board of directors. As a result, the preferred stock typically pays out more predictable and higher dividends than common stock. Preferred shareholders do not have voting rights like common shareholders. In general, preferred shareholders are paid before common shareholders but after creditors. However, if a company does not have enough cash to pay all its creditors and preferred shareholders in full, common shareholders may receive nothing. 

What is a common dividend?

Dividend payments are made to common shareholders on a pro-rata basis, meaning that each shareholder receives a dividend in proportion to the number of shares they own. If a company declares a dividend, it will set a record date, which is the date that determines which shareholders are eligible to receive the dividend payment. Shareholders who owned the stock before that date are known as "record holders," and they are typically entitled to receive the dividend.

What is a special dividend?

Special dividends are one-time dividend payments that are outside of the company's usual dividend schedule. Companies may declare special dividends for a variety of reasons, such as to return excess cash to shareholders or to celebrate a milestone. While special dividends can be a nice windfall for investors, they are not necessarily an indicator of a company's financial health. So, before investing in a company that has declared a special dividend, be sure to do your research to ensure that the dividend is sustainable.

What is a stock dividend?

Most dividends are paid in cash. The opposite of cash dividends is stock dividends - so you receive stocks instead of money. It is often used to increase the number of shares outstanding without issuing new shares (issuing new shares dilutes the value of existing shares). A stock dividend can also be used to pay shareholders who do not want to sell their shares (e.g., retired investors). Finally, a stock dividend can be used to avoid taxes on dividends (e.g., when a company is located in a high-tax jurisdiction).

What is a property dividend?

Property dividends are a type of dividend in which shareholders receive assets, rather than cash, as their dividend payment. Property dividends can take the form of stocks, bonds, or even real estate. While property dividends offer several advantages to shareholders, they also come with some risks. For example, if the company that issues the property dividend goes bankrupt, shareholders may lose their investment entirely. As such, it is important for investors to carefully consider their options before investing in property dividends.

What does dividend per share mean?

Dividend per share (DPS) is a ratio that measures the amount of cash dividends paid out to shareholders for each share of stock they own. DPS is typically expressed as an absolute amount, but it can also be expressed as a percentage of the stock's price. For example, if a company has a DPS of $0.50 and the share price is $10.00, the dividend yield would be 5%.

What is a dividend reinvestment plan?

A dividend stock reinvestment plan (DRIP) is a program that allows shareholders to automatically reinvest their dividends in additional shares of stock. DRIPs are offered by many companies as a way to encourage shareholder loyalty and to provide a discount on future share purchases.

What does dividend yield mean?

A dividend yield is the percentage of a company's current share price that it pays out in dividends each year. For example, if a company has a dividend yield of 5%, and its shares are currently trading at $100, that means the company pays out $5 in dividends for each share each year. Dividend yields can be a helpful tool for investors when assessing whether or not to invest in a particular stock. However, it's important to remember that dividend yields are just one factor to consider; other factors such as the company's overall financial health, growth prospects, and competitive landscape should also be taken into account.

What does dividend growth mean?

Dividend growth refers to the increases in the amount of the dividend that a company pays to its shareholders over time. For example, if a company pays a dividend of $0.50 per share in one year and then increases the dividend to $0.60 per share the following year, the company has experienced 20% dividend growth. The key figure is important because it provides investors with a way to measure the company's profitability and prospects. Companies that are growing their dividends are generally doing so because they believe they will be able to continue to grow their profits at a similar rate. This can be seen as a vote of confidence from management. Investors seeking companies with strong dividend growth prospects should look for companies with high-profit margins and strong cash flow. In addition, it is often helpful to look for companies that have increased their dividend payment in each of the last few years. This consistent growth is usually a good sign that the company's prospects remain strong.

What does dividend total return mean?

To calculate the dividend total return, you need to know the last mentioned terms. The formula for calculating dividend total return is:

So for example, if a company has a dividend yield of 10% and a growth rate of 10%, the dividend total return would be 20%. It's important to keep in mind that many factors can affect a company's dividend yield and growth rate. For example, a company might choose to reinvest its profits back into the business instead of paying them out as dividends. This could lead to higher growth in the future, but it would also decrease the current dividend yield.

What is the dividend payout ratio?

At this point, it exists more than just one way to calculate it. Some say it is the percentage of a company's profits that are paid out in dividends. Other calculating them by dividing the total amount of dividend payments during a given period by the company's free cash flow. For example, if a company realized a cash flow of $100 million last year and paid out $40 million in dividends, its dividend payout ratio would be 40% - To keep it short, at this point, the second perspective is the better one. You can learn this in a later chapter. The ratio can be a useful tool for investors when evaluating stocks, as it can give them an idea of how much cash flow the company has available to reinvest in its business or payout to shareholders. It can also be used to compare companies within the same industry to see which one is more generous with its shareholders.

What is the difference between ex-dividend and record date?

 

The ex-dividend date is the date on which a stock begins trading without its dividend. So the dividend is paid to the shareholders of record as of the close of business on the ex-dividend date. To receive the dividend, you must own the stock before the ex-dividend date. The ex-dividend date is usually two business days before the record date. For example, if a company declares a dividend on December 4th and the ex-dividend date would be December 15th, the record date would be December 17th.

Why Invest In Dividend Stocks?

Dividend stocks are a great way to start investing. Many people shy away from them because they think that they are only for experienced investors, but that is not the case at all. There are many benefits to investing in dividend stocks, even if you are a beginner. Dividend stocks can provide you with regular income, which can help you build your wealth over time. They can also provide some stability during tough times in the market. If you are looking for a way to get started in investing, dividend stocks may be the right choice for you.

What is passive income?

Passive income is money that you earn without having to work for it. This can come in the form of interest from investments, rental income from property, or even dividend payments from stocks. To push your passive income, you should also use a dividend reinvestment strategy. Passive income can provide you with a regular stream of income, which can help build your wealth over time.

What are the advantages of dividend-paying stocks? 

There are several reasons why you should consider putting your money into companies that pay out dividends. Some points I would like to highlight like followed:

Regularity

Dividend stocks can provide you with a regular stream of income that can help you build your wealth over time. This is especially helpful if you are retired or have other sources of income that are not as reliable.

Amortization / Planable

Amortization means, do you and when do you earn back your invested money. So let's dive into a simplified example (no taxes, discounting considered and stable dividends are assumed): By buying a dividend stock for $100 with a dividend yield of 5% means, that it takes 20 years until you have to get your entry price back. So if the stock price at the end is $50, then it is a profit. To get to the point, dividend stocks are better to handle when it comes to investment decisions and financial planning. You never can do such a calculation with non-dividend stocks and their stock price.

Stability

Dividend Stocks and their share price are usually considered to be one of the more stable investments when compared with other types. Dividend stocks traditionally outperformed stocks of stock markets and have been more stable. This is because dividends provide both incomes of dividend payments and a possible capital increase for shares. Dividends are kind of an exit barrier. Additionally, companies that pay dividends tend to do everything to have a stable or growing dividend, which serves investors as a push in confidence, especially during tough economic times.

Hedging

Dividends can help to hedge against inflation because when prices rise, the value of your dividends will also increase. But let's have a look at a simplified example:

In both cases, you start with $1K. The first case is when there's no interest earned on your savings account and the price of a phone goes up by 2%. In that situation, you would lose purchasing power. The price of the phone tends to be more expensive but your savings have the same value over time. Case two shows what happens if someone invests in stocks that pay dividends whose yield averages out at 5%. Without considering any price changes, the results are better than in case 1.

Evaluation Purpose

Dividends can provide valuable information about a company's performance. The payout ratio can help you assess whether a company is generating enough cash to cover its dividend payments. Solid dividend growth rates can indicate stable and predictable income. Conversely, if a dividend is cut or eliminated, it may be a sign that the company is facing difficult financial conditions. The last point seems like a disadvantage but this may be a signal to look for a better investment opportunity.

What is the downside to dividend stocks?

Dividend Cuts

Dividends are not guaranteed. The stock price of a company that normally pays stable dividends is reacting sensitively when it comes to dividend cuts or unexpected bad news - so volatility is going up. The reasons are in the opposite direction like the point mentioned in the advantage section.

Growth

Dividend stocks may not provide the same potential for capital gains as other types of investments, because that cash is not used for investment opportunities.

Taxes

Taxes can also take a bite out of dividend income. Dividends are subject to income tax, so investors will need to factor this into their overall return and preferential tax treatment. For investors who are looking for tax-advantaged income, other options may be more attractive.

How to buy dividend stocks?

Dividend stocks can be bought in the same way as any company stock - through a broker. You can also buy them through a mutual fund or exchange-traded fund that specializes in dividend-paying stocks.

On this site, we are talking about the first mentioned way because you can set up your preferences like looking for high dividends, dividend growth and you can buy stocks from any part of the world with any size and the fundamentals you prefer. Last but not least you decide whether to sell or to hold a stock in your portfolio. With funds, you have the advantage that you do have not to manage that all. You decide which fund and buy it, that's it.

When choosing individual stocks to invest in, your selection criteria must be based on the following:

• At least 5 years of historical data of paying dividends,
• dividends that are stable or increasing over time, but do not consider special dividends,
• get an idea of the dividend payout ratio and compare it to its competitors - here you can find the indicator per industry,
• Have also a look at the equity ratio and compare it to the competitor's ratio,
• the fundamentals of your preferred stock should come up with stable or growing cash flows