Dividend

A dividend is a cash payment that a company sends to people who own its stock.

Since a stock represents part ownership of a companya dividend payment is really about the company sending some of its profits to its owners.

Most U.S. stocks that pay dividends do so each quarter on a fixed schedule. Every three monthsyou receive cash via direct deposit into your brokerage account or a check in the mail.

For exampleif you own 100 shares of a stock with a $1 quarterly dividendthen you will receive $100 every three monthsfor a total of $400 per year.

In order to receive a dividend paymentyou need to buy the stock before a date called the ex-dividend date.

How do dividends work?

When companies become consistently profitablethey often start accumulating excess cash on their balance sheet.

If they don't need to reinvest all of this cash back into the businessthey 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 dividendsand how much to pay. When they have decidedthey 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 cashalthough they can sometimes be paid in other formssuch 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 DRIPswhich stands for dividend reinvestment programs.

Dividend payments are usually fairly reliable and are often increased each year. Howeverthey can also be decreased or even cut off completely if the company's board of directors thinks it is necessary.

Howevercompanies usually do not decrease or eliminate their dividends unless they are in financial trouble. When dividend cuts are announcedit 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 earningsand are listed on a company's balance sheet.

A company will outline its dividend strategy in its dividend policywhich 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 stockssuch 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 payersbecause their legal structure obligates them to pay 90% of their income as dividends.

At the same timemost startups and many tech and biotech stocks pay either low or no dividends.

That's because many of these companies either operate at a lossor they are profitable but prefer to reinvest their earnings back into the business to fuel further growth.

As companies like this maturethey often start paying dividends eventually.

Dividend examples

Apple pays its shareholders $0.77 every quarterfor every stock owned. This amounts to $3.08 per year.

If you own 100 shares of Apple stockthen you will get $77 every three monthsor $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 dividendbut 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 quarteror $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 accountit'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.

Soyou can calculate the dividend yield by 1) adding up the dividend payments for a full yearthen 2) dividing by the stock priceand 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 $63.33their yield is (($0.50*4) / $63.33) * 100% = 3.16%.

Other well-known companies that pay dividends include Microsoft (1.11% yield)Walmart (1.74%)Target (2.25%)Coca Cola (3.64%)McDonald's (2.71%) and Starbucks (2.11%).

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 additionthere are "irregular" dividendsmeaning they are paid irregularly with no fixed schedule.

Then there are "special" dividendswhich 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 yearsin 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 datethis is the date that the board of directors announces the dividend paymentex-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 datethen you will receive the dividend payment.

Howeverthe 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 investmentssuch 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 holdthen distribute them to investors once per quarter.

Some ETFs invest specifically in stocks with high yields and/or consistent dividend growth.

One example is SPYDwhich invests in the 80 companies in the S&P500 with the highest yields. Another example is DGROwhich invests specifically in high-quality stocks that are growing their dividends regularly.

Types of dividends

In the majority of casesdividends are regular cash payments paid to owners of a company's common stock. These are also termed cash dividends.

Howeverthere are several other types of dividends worth knowing about:

Stock dividends: In some casescompanies 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 dividendsbonds 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 USdividends can be classified as either "ordinary" or "qualified."

Ordinary dividends are taxed as regular incomeso the tax rate is the same as your income tax rate. This can vary from 10% to 37%depending on your income.

Howeverqualified 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 categoryand most investors fall under the 15% tax.

Soif you are an average US investoryour dividends will likely be taxed at 15%.

If you invest through a tax-advantaged account like a 401(k) or Roth IRAthen you will not owe taxes on the dividend income that was generated within the account until you withdraw the money. In a Roth IRAqualified dividends can even be withdrawn without having to pay taxes.

Because of taxesmany 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 taxso 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 dividendsbut 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 stocksyou can experience significant income growth over the long-term.

The plan is often to grow the dividend income each year until retirementthen 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 ratiothe more likely it is that the dividend is unsustainable. For exampleif 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.

Howevernet income is based on accounting earningswhile 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 futurethen that can make the current payouts unsustainable.

Don't chase high dividend yields

Although dividends are generally a good thingit 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 samethe percentage yield increases. If the stock price increases without a corresponding increase in the payoutthen 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 pooror if the business is in financial trouble.

Because of thisstocks 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 stockswhich often yield over 5% without problems.

Importantlydividends are just one part of the returns you get from investing in stocks. Long-term gains in stock prices are just as important.