A dividend is a cash payment that a company sends to people who own its stock.
Since a stock represents part ownership of a company, a dividend payment is really about the company sending some of its profits to its owners.
Most US stocks that pay dividends do so each quarter on a fixed schedule. Every three months, you receive cash via direct deposit into your brokerage account or a check in the mail.
For example, if you own 100 shares of a stock with a $1 quarterly dividend, then you will receive $100 every three months, for a total of $400 per year.
In order to receive a dividend payment, you need to buy the stock before a date called the ex-dividend date.
How do dividends work?
When companies become consistently profitable, they often start accumulating excess cash on their balance sheet.
If they don’t need to reinvest all of this cash back into the business, they often start returning money to shareholders (stock owners) via regular dividend payments.
Companies are not obligated to pay dividends. But this is usually preferred by shareholders if there is no way for the company to invest the money more profitably.
A company’s board of directors is responsible for deciding whether to pay dividends, and how much to pay. When they have decided, they usually issue a press release.
You can find the press release on the investor relations website of the company. An easy way to find this website is to type the company name into Google along with “investor relations.”
Dividends are paid as a fixed amount per share. They are almost always paid in cash, although they can sometimes be paid in other forms, such as additional shares of stock.
Some companies and stock brokers also offer automated ways for investors to reinvest their dividends into more shares of the stocks. These programs are called DRIPs, which stands for dividend reinvestment programs.
Dividend payments are usually fairly reliable and are often increased each year. However, they can also be decreased or even cut off completely if the company’s board of directors thinks it is necessary.
However, companies usually do not decrease or eliminate their dividends unless they are in financial trouble. When dividend cuts are announced, it often causes a big decline in the stock price.
The total amount that a company pays in cash dividends is reported on its cash flow statement. Profits that are not sent to shareholders as dividends are termed retained earnings, and are listed on a company’s balance sheet.
A company will outline its dividend strategy in its dividend policy, which can be found in the company’s annual report (10K).
Which types of stocks pay dividends?
Paying dividends is more common among mature and well-established companies that don’t need to invest all of their earnings in growth anymore.
Dividend payouts also depend on the industry. Stocks in industries that are mature and have limited growth potential tend to pay much higher dividends.
These are the types of stocks that often pay high dividends:
- Utility stocks
- Energy stocks, such as oil and gas companies
- Healthcare and pharmaceutical stocks
- Banks and financial stocks
- Basic materials stocks
- Real estate stocks
- Retail stocks
Real Estate Investment Trusts (REITs) are among the best dividend payers, because their legal structure obligates them to pay 90% of their income as dividends.
At the same time, most startups and many tech and biotech stocks pay either low or no dividends.
That’s because many of these companies either operate at a loss, or they are profitable but prefer to reinvest their earnings back into the business to fuel further growth.
As companies like this mature, they often start paying dividends eventually.
Apple pays its shareholders $0.77 every quarter, for every stock owned. This amounts to $3.08 per year.
If you own 100 shares of Apple stock, then you will get $77 every three months, or $308 per year. The cash is deposited directly into your brokerage account or sent via a check in the mail.
Not only does Apple pay a dividend, but it is also increasing its payment each year. The quarterly payout has increased by more than 50% since 2015.
CVS Health is another company that pays a dividend. The current payout is $0.50 per quarter, or $2.00 per year. CVS has temporarily stopped increasing its dividend each year because it needs to pay off debts.
How to calculate the dividend yield
The dividend yield is the percentage of the stock price that is paid back to shareholders each year. It is kind of like the yield on a bank account, it’s what you get paid for keeping your money invested in the stock.
The formula is: Dividend Yield = Annual Dividend / Stock Price.
Then you can multiply by 100% to convert to a percentage.
So, you can calculate the dividend yield by 1) adding up the dividend payments for a full year, then 2) dividing by the stock price, and 3) multiplying by 100%.
Here’s how the dividend yield for Apple stock is calculated given a stock price of $318.89:
- $0.77 * 4 = $3.08
- $3.08 / $318.89 = 0.00966
- 0.00966 * 100% = 0.966%
CVS Health’s dividend yield can be calculated in the same way. With a current stock price of $63.33, their yield is (($0.50*4) / $63.33) * 100% = 3.16%.
How often do stocks pay dividends?
Companies pay dividends on different schedules:
- Quarterly: Paying dividends every three months is most common among US companies.
- Semi-annually: Some companies pay dividends every six months.
- Annually: Paying a dividend once per year is common for European stocks.
- Monthly: A few companies pay each month. One example is Realty Income Corporation.
In addition, there are “irregular” dividends, meaning they are paid irregularly with no fixed schedule.
Then there are “special” dividends, which are usually one-time payments when a company has a lot of excess cash to distribute to shareholders.
Costco has paid special dividends three times in the past ten years, in addition to their regular (and growing) quarterly dividend payments.
Important dates for dividend payments
Dividend investors need to be aware of four different dates:
- Declaration date: Also called the announcement date, this is the date that the board of directors announces the dividend payment, ex-dividend date and payment date.
- Ex-dividend date: Everyone who owns the stock before the ex-dividend date gets paid.
- Record date: This is the date when the company looks at its records to determine who is eligible for the payment.
- Payment date: The dividend payment is sent to stock owners on the payment date. It should arrive in their account soon after.
The most important date is the ex-dividend date. If you buy the stock on the day before the ex-dividend date and hold it during market open on the ex-dividend date, then you will receive the dividend payment.
However, the stock price usually goes down by the same amount as the dividend payment on the ex-dividend date.
So it’s generally not a profitable strategy to buy stocks before the ex-dividend date and then sell them right after.
Read this article for more information on dividend payments and dates: How Often Do Stocks Pay Dividends? And When?
ETFs and mutual funds can also pay dividends
You can also get dividends from other types of investments, such as ETFs and mutual funds. ETFs that hold the S&P500 index currently have a yield of around 2%.
ETFs take the dividend payments from the companies they hold, then distribute them to investors once per quarter.
Some ETFs invest specifically in stocks with high yields and/or consistent dividend growth.
One example is SPYD, which invests in the 80 companies in the S&P500 with the highest yields. Another example is DGRO, which invests specifically in high-quality stocks that are growing their dividends regularly.
Types of dividends
In the majority of cases, dividends are regular cash payments paid to owners of a company’s common stock. These are also termed cash dividends.
However, there are several other types of dividends worth knowing about:
- Stock dividends: In some cases, companies pay their dividends as additional shares of stock instead of cash.
- Preferred dividends: Owners of preferred stock get fixed dividend payments and their payments have priority over the payments to common stock owners. Preferred stocks are similar to bonds in many ways.
- Special dividends: These are irregular one-time dividend payments made when companies have a lot of spare cash to distribute.
Although not technically dividends, bonds and bond ETFs also pay regular interest. The amount a bond pays in interest is termed the bond’s “coupon.”
What taxes do you need to pay?
Taxes are highly variable between countries and depend on a number of factors.
In the US, dividends can be classified as either “ordinary” or “qualified.”
Ordinary dividends are taxed as regular income, so the tax rate is the same as your income tax rate. This can vary from 10% to 37%, depending on your income.
However, qualified dividends are taxed at the same rate as long-term capital gains. This rate can be 0%, 15% or 20%, depending on your tax bracket.
Most dividends fall under the “qualified” dividend category, and most investors fall under the 15% tax.
So, if you are an average US investor, your dividends will likely be taxed at 15%.
If you invest through a tax-advantaged account like a 401(k) or Roth IRA, then you can avoid paying taxes on dividends up to a certain limit each year.
Because of these taxes, many companies prefer to return money to shareholders via stock buybacks instead of dividends.
Buybacks increase the value of the remaining stocks without investors having to pay a tax, so this is technically more tax-efficient for long-term investors.
Income investing and dividend growth
Dividend growth investing is a form of income investing. It focuses on stocks and ETFs that not only pay dividends, but also increase their payouts each year.
If you invest mostly in stocks that grow their payouts each year and then reinvest the payments into even more dividend stocks, you can experience significant income growth over the long-term.
The plan is often to grow the dividend income each year until retirement, then being able to live comfortably off of the dividend payments.
S&P500 stocks that have raised their payouts every year for 25 or more years in a row are called dividend aristocrats.
The payout ratio can help determine the safety of the dividend
It is very important to consider the payout ratio before investing. This is the percentage of a company’s earnings that is paid out as dividends.
A ratio of 50% implies that half of the company’s earnings are paid out as dividends.
The higher the payout ratio, the more likely it is that the dividend is unsustainable. For example, if a stock has a payout ratio higher than 100%, then the company may need to go into debt in order to afford the payments.
The most common way to calculate the payout ratio divides the total amount paid in dividends in a year by the company’s annual net income.
This is the formula: Payout Ratio = Dividends / Net Income.
You can find a company’s net income on its income statement. Its total dividend payment is shown on the cash flow statement.
However, net income is based on accounting earnings, while dividends are based on cash. This can be misleading in some cases.
A popular alternative formula uses free cash flow instead of net income. This formula may be more accurate to determine the sustainability of cash dividends.
Alternative formula: Payout Ratio = Dividends / Free Cash Flow.
You can calculate the free cash flow from the income statement by subtracting capital expenditures from the operating cash flow.
Keep in mind that the payout ratio alone can not guarantee that a dividend is safe. If the company’s revenues and profits take a hit in the future, then that can make the current payouts unsustainable.
Don’t chase high dividend yields
Although dividends are generally a good thing, it is a really bad idea to buy stocks only because they have high yields.
Stocks with very high dividend yields have usually had significant declines in their stock prices.
If the stock price drops and the dividend payout remains the same, the percentage yield increases. If the stock price increases without a corresponding increase in the payout, then the yield goes down.
A high yield due to a significant decline in stock price usually only happens if the company’s growth prospects are poor, or if the business is in financial trouble.
Because of this, stocks with very high yields often end up cutting their dividend payments either partly or entirely. This can lead to big losses for investors who bought the stocks solely because of their high yields.
If you see a dividend yield that is higher than 4-5%, then that is a potential red flag that warrants further research into why the yield is so high.
One exception is for REIT stocks, which often yield over 5% without problems.
Importantly, dividends are just one part of the returns you get from investing in stocks. Long-term gains in stock prices are just as important.