Dividends: What They Are, How They Work, and Important Dates

What Are Dividends?

Dividends are a percentage of a company's earnings paid to its shareholders as their share of the profits. Dividends are generally paid quarterly, with the amount decided by the board of directors based on the company's most recent earnings.

Dividends may be paid in cash or additional shares. When a company announces a dividend, it also announces the payment date on which the dividend will be paid into the shareholders' accounts.

How Dividends Work

A dividend is a reward paid to the shareholders for their investment in a company, and it's usually paid out of the company's net profits. Some companies continue to make dividend payments even when their profits don't justify the expense. A steady track record of paying dividends makes stocks more attractive to investors. Various mutual funds and exchange-traded funds (ETFs) also pay dividends.

Dividends (for stocks) must be approved by the company's board of directors. In some cases, they also require shareholder approval. For funds, the fund managers award dividends based on the fund's net asset value (NAV) and whether the fund receives dividends. Although cash dividends are common, dividends can also be issued as shares of stock.

Who Gets Dividends and How

Common stock shareholders of dividend-paying companies are eligible to receive a distribution as long as they own the stock before the ex-dividend date. This is essentially a cutoff date for assigning the dividend payment when shares change hands.

Dividends are paid on a schedule set by the board. They may be paid monthly, quarterly, or annually. Companies can also issue non-recurring special dividends, either individually or in addition to a scheduled dividend.

Dividend-Paying Companies

Larger, established companies with predictable profits are often the best dividend payers. Companies within the following industry sectors maintain a regular record of dividend payments:

• Basic materials
• Oil and gas
• Banks and financial
• Health care and pharmaceuticals
• Utilities

Companies structured as master limited partnerships (MLPs) and real estate investment trusts (REITS) are required to make specified distributions to their shareholders.

Funds may also issue regular dividend payments as stated in their investment objectives.

Who Doesn't Pay a Dividend?

Young, fast-growing companies, such as those in the technology and biotechnology sectors, might not pay regular dividends since they may be in the early stages of development and are retaining all of their earnings for research and development, business expansion, or operational activities. Investors tend to forgive the lack of a dividend if the company's stock price is growing rapidly.

Not surprisingly, once a company begins paying dividends, it's typically difficult to reduce or suspend the payments. Doing so is generally viewed by investors as a sign of falling profits, not to mention a loss of income.

Important Dividend Dates

Dividend payments follow a chronological order of events, and the associated dates are important in determining which shareholders qualify to receive the dividend payment:

• Announcement date: Dividends are announced by company management on the announcement date (or declaration date) and must be approved by the shareholders before they can be paid.
• Ex-dividend date: The date on which the dividend eligibility expires is called the ex-dividend date or simply the ex-date. For instance, if a stock has an ex-date of Monday, May 5, shareholders who buy the stock on or after that day will NOT qualify to receive the dividend. Shareholders who own the stock one business day prior to the ex-date (i.e., Friday, May 2) or earlier qualify for the distribution.
• Record date: The record date is the cutoff date, established by the company to determine which shareholders are eligible to receive a dividend or distribution.
• Payment date: The company issues the dividend payment on the payment date, which is when the money is credited to investors' accounts.

How Do Dividends Affect a Stock's Share Price?

A stock's share price may change to reflect a dividend payment.

For example, assume a company trading at $60 per share declares a $2 dividend. As the news becomes public, the share price may increase by $2 and hit $62.

The stock might trade at $63 one business day before the ex-dividend date. On the ex-dividend date, its price will likely fall below its previous price at the start of the trading session, as anyone buying on the ex-dividend date won't receive the dividend.

Why Do Companies Pay Dividends?

Many investors buy stocks for their dividends rather than their share price growth potential. Some extraordinarily successful companies like Coca-Cola Co. are prized more by investors for their steady dividends than for their potential price growth.

Dividends are often expected by shareholders as their share of the company's profits. Dividend payments reflect positively on a company and help maintain investors' trust.

A high-value dividend declaration can indicate that a company's doing well and has generated good profits. However, some may interpret it as an indication that the company doesn't have much going on in the way of new projects to generate better returns in the future. The company may appear to be prioritizing shareholder payments over reinvesting its earnings into further growth.

A company with a long history of dividend payments that declares a reduction or elimination of its dividend typically signals trouble. However, a dividend cut doesn't necessarily translate into bad news. The company's management may have a plan for investing the money in a high-return project that could magnify returns for shareholders in the long run.

Fund Dividends

Dividends paid by funds are different from dividends paid by companies. Funds employ the principle of NAV, which reflects the valuation of their holdings or the price of the assets a fund has in its portfolio.

Regular dividend payments shouldn't be misread as a stellar performance by the fund. For example, a bond-investing fund may pay monthly dividends because it receives monthly interest on its interest-bearing holdings, and it merely transfers all or a portion of the interest income to the fund's investors.

A stock-investing fund pays dividends from the earnings received from the many stocks held in its portfolio or by selling a certain share of stocks and distributing capital gains.

Are Dividends Irrelevant?

Economists Merton Miller and Franco Modigliani argued that a company's dividend policy is irrelevant and has no effect on its stock price or cost of capital.

A shareholder may be indifferent to a company's dividend policy, especially if the dividend is used to buy more shares. If a dividend payout is seen as inadequate, an investor can sell shares to generate cash.

In either case, the combination of the value of an investment in the company and the cash they hold will remain the same. Miller and Modigliani thus conclude that dividends are irrelevant, and investors shouldn't care about the firm's dividend policy because they can create their own synthetically.

This argument has done little to persuade the many investors who consider dividends an attractive investment incentive.

How to Buy Dividend-Paying Investments

Investors seeking dividend investments have several options, including stocks, mutual funds, and ETFs.

The dividend discount or Gordon growth models can help investors choose individual stocks. These techniques rely on anticipated future dividend streams to value shares.

To compare multiple stocks based on their dividend payment performance, investors can use the dividend yield factor, which measures the dividend in terms of a percentage of the current market price of the company’s share.

How to Measure Dividends

The dividend rate can be quoted in terms of the dollar amount each share receives as dividends per share (DPS).

In addition to dividend yield, another important performance measure to assess the returns generated from a particular investment is the total return factor. This figure accounts for interest, dividends, and increases in share price, among other capital gains.

Tax is another important consideration when investing in dividend gains. Investors in high tax brackets often prefer dividend-paying stocks if their jurisdiction allows zero or comparatively lower tax on dividends.

The Bottom Line

Dividends are seen by many investors as a sign that a company is earning a healthy profit and, more to the point, is willing to share it with its investors. Not all companies pay dividends, and not all investors care about them. If you do, then it's important to shop around for the best dividend-paying stocks for your money.