Dividends Work

The Beginner's Step-By-Step Overview of How Dividends Work

Have you ever wondered what it would be like to sit at home, reading by the pool, living off dividend checks that arrive regularly through the mail?  This common dream can become a reality, but before you can even hope to achieve that level of financial independence, you must understand what dividends are, how companies pay dividends, and the different types of dividends that are available such as cash dividends, property dividends, stock dividends, and liquidating dividends, just to name a few.

That's why I put together this step-by-step Dividends 101 resource. It will walk you through the basics, ensuring that you have a solid foundation before diving into the more practical content in our Ultimate Guide to Dividends and Dividend Investing. By starting here, you'll learn to avoid tax traps such as buying dividend stocks between the ex-dividend date and the distribution date, effectively forcing you to pay other investors' income taxes! You'll also learn why some companies refuse to pay dividends while others pay substantially more, how to calculate dividend yield, and how to use dividend payout ratios to estimate the maximum sustainable growth rate.

Clear off your desk, grab a pen and notepad, and pour a cup of coffee (or tea if you prefer). You're about to embark on a journey that will put you years ahead of other new investors on understanding dividends and the important role they play in your investment portfolio.

01

How a Company Pays Dividends and the Three Dividend Dates that Matter to You

•••Before a company can pay cash dividends to shareholders, it has to go through a legal checklist that includes declaring a declaration date, ex-dividend date, date of record, and distribution date. As an investor, you need to know what these represent. kyoshino/Getty Images

Companies that earn a profit can do one of three things: pay that profit out to shareholders, reinvest it in the business through expansion, debt reduction or share repurchases, or both. When a portion of the profit is paid out to shareholders, the payment is known as a dividend. For many investors, "living off dividends" is the ultimate goal (for more information about this, you can read the 10 Part Guide to Income Investing).

During the first part of the twentieth century, dividends were the primary reason investors purchased stock. It was literally said on Wall Street, “the purpose of a company is to pay dividends”. Today, the investor’s view is a bit more refined; it could be stated, instead, as, “the purpose of a company is to increase my wealth.” Indeed, today’s investor looks to dividends and capital gains as a source of increase. Microsoft, for example, did not pay a dividend until it had already become a $350 billion company, long after making the company’s founders and long-term shareholders multi-millionaires or billionaires.

The Process

Dividends must be declared (i.e., approved) by a company’s Board of Directors each time they are paid. There are three important dates to remember regarding dividends.

• Declaration date: The declaration date is the day the Board of Directors announces their intention to pay a dividend. On this day, the company creates a liability on its books; it now owes the money to the stockholders. On the declaration date, the Board will also announce a date of record and a payment date.
• Date of record: This date is also known as “ex-dividend” date. It is the day upon which the stockholders of record are entitled to the upcoming dividend payment. According to Barron’s, a stock will usually begin trading ex-dividend or ex-rights the fourth business day before the payment date. In other words, only the owners of the shares on or before that date will receive the dividend. If you purchased shares of Coca-Cola after the ex-dividend date, you would not receive its upcoming dividend payment; the investor from whom you purchased your shares would.
• Payment date: This is the date the dividend will actually be given to the shareholders of the company.

A vast majority of dividends are paid four times a year on a quarterly basis. This means that when an investor sees that, for example, Coca-Cola pays an $0.88 dividend, he will actually receive $0.22 per share four times a year. Some companies, such as McDonald’s, pay dividends on an annual basis.


02

Cash Dividends, Property Dividends, and Special One-Time Dividends

•••Cash dividends literally represent money sent to you in the mail or direct deposited into your bank account. The goal of successful investing is to be able to have cash dividends pour into your life regularly so you don't need to work unless you desire. Florence Delva/Getty Images

Cash Dividends

Regular cash dividends are those paid out of a company’s profits to the owners of the business (i.e., the shareholders). A company that has preferred stock issued must make the dividend payment on those shares before a single penny can be paid out to the common stockholders. The preferred stock dividend is usually set whereas the common stock dividend is determined at the sole discretion of the Board of Directors (for reasons discussed later, most companies are hesitant to increase or decrease the dividend on their common stock). You can find a detailed discussion of preferred stock and its dividend provisions in The Many Flavors of Preferred Stock: A Possible Investment for Your Fixed Income Portfolio.

Property Dividends

A property dividend is when a company distributes property to shareholders instead of cash or stock. Property dividends can literally take the form of railroad cars, cocoa beans, pencils, gold, silver, salad dressing or any other item with tangible value. Property dividends are recorded at market value on the declaration date.

Special One-Time Dividends

In addition to regular dividends, there are times a company may pay a special one-time dividend. These are rare and can occur for a variety of reasons such as a major litigation win, the sale of a business, or liquidation of an investment. They can take the form of cash, stock, or property dividends. Due to the temporarily lower rates of taxation on dividends, there has been an increase in special dividends paid in recent years.

To add sugar to spice, there are times when these, special one-time dividends are classified as a “return of capital”. In essence, these payments are not a payout of the company’s profits but instead a return of money shareholders have invested in the business. As a result, return of capital dividends are tax-free.

Special one-time dividends sometimes offer an opportunity for arbitrage.

03

Stock Dividends and How They are Different From Stock Splits

•••Stock dividends are issued when a firm mails additional shares of stock to the owners instead of, or in addition to, cash dividends. Although you aren't any richer with stock dividends that you were before, there are strong psychological benefits. George Diebold/Getty Images

Stock Dividends

A stock dividend is a pro-rata distribution of additional shares of a company’s stock to owners of the common stock. A company may opt for stock dividends for a number of reasons including inadequate cash on hand or a desire to lower the price of the stock on a per-share basis to prompt more trading and increase liquidity (i.e., how fast an investor can turn his holdings into cash). Why does lowering the price of the stock increase liquidity? On the whole, people are more likely to buy and sell a $50 stock than a $5,000 stock; this usually results in a large number of shares trading hands each day.

A Practical Example of Stock Dividends:

Company ABC has 1 million shares of common stock. The company has five investors who each own 200,000 shares. The stock currently trades at $100 per share, giving the business a market capitalization of $100 million.

Management decides to issue a 20% stock dividend. It prints up an additional 200,000 shares of common stock (20% of 1 million) and sends these to the shareholders based on their current ownership. All of the investors own 200,000, or 1/5 of the company, so they each receive 40,000 of the new shares (1/5 of the 200,000 new shares issued).

Now, the company has 1.2 million shares outstanding; each investor owns 240,000 shares of common stock. The 20% dilution in value of each share, however, results in the stock price falling to $83.33. Here’s the important part: the company (and our investors) are still in the exact same position. Instead of owning 200,000 shares at $100, they now own 240,000 shares at $83.33. The company’s market capitalization is still $100 million.

A stock split is, in essence, a very large stock dividend. In cases of stock splits, a company may double, triple or quadruple the number of shares outstanding. The value of each share is merely lowered; economic reality does not change at all. It is, therefore, completely irrational for investors to get excited over stock splits. If you do not still fully understand this, you must read How to Think About Share Price. It will clear up any lingering confusion.

One of the more interesting theories of corporate dividend policy is that managements should opt for stock dividends over all other kinds. This will allow investors that want their earnings retained in the business (and not taxed) to hold on to the additional stock paid out to them. Investors that want current income, on the other hand, can sell the shares they receive from the stock dividend, pay the tax and pocket the cash - in essence, creating a “do-it-yourself” dividend.

04

Corporate Dividend Policy, Dividend Payout Ratio, and Dividend Yield

Whether or not high dividends are good or bad depends upon your personality, financial circumstances, and the business itself.

In Determining Dividend Payout: When Should Companies Pay Dividends?, you learned that, “a company should only pay dividends if it is unable to reinvest its cash at a higher rate than the shareholders (owners) of the business would be able to if the money was in their hands. If company ABC is earning 25% on equity with no debt, management should retain all of the earnings because the average investor probably won't find another company or investment that is yielding that kind of return.”
At the same time, an investor may require cash income for living expenses. In these cases, he is not interested in long-term appreciation of shares; he wants a check with which he can pay the bills.

Dividend Payout Ratio

The percentage of net income that is paid out in the form of a dividend is known as the dividend payout ratio. This ratio is important in projecting the growth of company because its inverse, the retention ratio (the amount not paid out to shareholders in the form of dividends), can help project a company’s growth.

Calculating Dividend Payout Ratio

In 2003, Coca-Cola's cash flow statement showed that the company paid $2.166 billion in dividends to shareholders. The income statement for the same year showed the business had reported a net income of $4.347 billion. To calculate the dividend payout ratio, the investor would do the following:

$2,166,000,000 dividends paid
---------(divided by)---------
$4,347,000,000 reported net income

The answer, 49.8%, tells the investor that Coca-Cola paid out nearly fifty percent of its profit to shareholders over the course of the year.

Dividend Yield

The dividend yield tells the investor how much he is earning on a common stock from the dividend alone based on the current market price. Dividend yield is calculated by dividing the actual or indicated annual dividend by the current price per share.

For sake of illustration, let's say The Washington Post pays an annual dividend of $7 and trades at $910 per share; Altria Group (formerly Philip Morris) pays an annual dividend of $2.72 and trades at $49.75 per share. By calculating dividend yield, the investor can compare the amount he would earn in cash income annually from each security.

Washington Post Dividend Yield Calculation
$7.00
----(divided by)----
$910
= 0.0077 or 0.77%
Altria Group Dividend Yield Calculation
$2.72
----(divided by)----
$49.75
= 0.055 or 5.5%

In other words, despite the fact that the Washington Post pays a higher per-share dividend, $100,000 invested in its common stock would yield only $770 in annual income as opposed to the same amount invested in Altria Group which would yield $5,500. An investor interested in dividend income and not capital gains should opt for the latter, all else being equal.

05 The Dividend Tax Debate

•••The IRS taxes dividends twice: Once when the company earns the money, and again when paid out to stockholders! In other countries, companies get a tax deduction to encourage managements to reward owners instead of building empires on their dime. H. Armstrong Roberts/ClassicStock/Getty Images

Dividends, like interest, are taxed at a person’s individual tax rate. Capital gain taxes, on the other hand, are assessed according to the length of time an investor held his investment and can be as low as half the rate levied on dividends income. This difference in tax treatment is another reason many investors opt for long-term equity holdings that reinvest capital into the business instead of paying it out in the form of a dividend; by avoiding the double-taxation, they can compound their wealth at a faster rate.

 

There is a significant dividend tax, or double taxation, political controversy. The corporation paid income taxes on the profit it earned (original tax). The owners of the business then take that profit out for their personal use in the form of a dividend and are taxed at personal income tax rates (second tax). In effect, they have paid the government twice.

 

The proponents of the dividend tax argue that the wealthy, by definition, own significantly more investments than the poor. Therefore, it would be possible for someone to earn billions of dollars in dividend income and not pay a dime in Federal taxes. This, they say, is inherently unfair. The gap between the rich and the poor would explode overnight.

 

For more information, read The Investor's Guide to the Dividend Tax - What the Dividend Tax Is and the Dividend Tax Rates. You may also want to read Dividend Tax - The Political Debate: Understanding the Double Taxation Fuss.

06

Selecting High Dividend Stocks

•••Selecting high dividend paying stocks is an art and science. By putting together a portfolio of dividend stocks, you can use the regular income to spend or to grow your business. Sam Edwards/Getty Images

Selecting High Dividend Stocks

An investor desiring to put together a portfolio that generates high dividend income should place great scrutiny on a company’s dividend payment history. Only those corporations with a continuous record of steadily increasing dividends over the past twenty years or longer should be considered for inclusion.

 

Furthermore, the investor should be convinced the company can continue to generate the cash flow necessary to make the dividend payments; a handgun manufacturer, for example, may have a long history of high dividend payments while generating strong cash flow from operations yet not make a good investment because it faces litigation which, if successful, will bankrupt the business.

Dividends Related to Cash Flow - Not Reported Earnings

This brings up an important point: dividends are dependent upon cash flow, not reported earnings. Almost any Board of Directors would still declare and pay a dividend if cash flow was strong but the company reported a net loss on a GAAP basis. The reason is simple: investors that prefer high dividend stocks look for stability. A company that lowers its dividend is probably going to experience a decline in stock price as jittery investors take their money elsewhere. Companies will not raise the dividend rate because of one successful year. Instead, they will wait until the business is capable of generating the cash to maintain the higher dividend payment forever. Likewise, they will not lower the dividend if they think the company is facing a temporary problem.

Debt Restrictions

Many companies are not able to pay dividends because bank loans, lines of credit, or other kinds of debt financing place strict limitations on the payment of common stock dividends. This type of covenant restriction is disclosed in a company’s 10K filing with the SEC.

07

Dividend Reinvestment Plans or DRIPs

•••When you use direct stock purchase plans, dividend reinvestment plans, or DRIPs, you pay little or no commission. This leaves more cash in your pocket. Wall Street doesn't advertise these programs because if you use them, it loses the fee income. Tatiana Maramygina / FOAP / Getty Images

Unless you need the money for living expenses or you are an experienced investor that regularly allocates capital, the first thing you should do when you acquire a stock that pays a dividend is enroll it in a dividend reinvestment plan, or DRIP for short.

How Dividend Reinvestment Plans Work

When an investor enrolls in a dividend reinvestment plan, he will no longer receive dividends in the mail or directly deposited into his brokerage account. Instead, those dividends will be used to purchase additional shares of stock in the company that paid the dividend. There are several advantages to investing in ​DRIPs; they

are:

• Enrolling in a DRIP is easy. The paperwork (both online and in print) can normally be filled out in under one minute.
• Dividends are automatically reinvested. Once the investor has enrolled in a DRIP, the process becomes entirely automated and requires no more attention or monitoring.
• Many dividend reinvestment plans are often part of a direct stock purchase plan. If the investor holds at least one of his shares directly, he can have his checking or savings account automatically debited on a regular basis to purchase additional shares of stock.
• Purchases through dividend reinvestment programs are normally subject to little or no commission.
• Dividend reinvestment plans allow the investor to purchase fractional shares. Over decades, this can result in significantly more wealth in the investor's hands.
• An investor can enroll only a limited number of shares in the dividend reinvestment plan and continue to receive cash dividends on the remaining shares.

In fact, I like dividend reinvestment programs so much that I once wrote an essay for my friends explaining how my family had used the Coca-Cola dividend reinvestment plan to teach my youngest sister how to invest in stock. It became a learning experience so that by the time she reached high school, she understood the relationship between business, profits, dividends and investors.

08

Practical Examples of Dividend Reinvestment Plans in Action

Full Enrollment in a DRIP: Example

Jane Smith owns 1,000 shares of Coca-Cola. The stock currently trades at $50 per share and the annual dividend is $0.88 per share. The quarterly dividend has just been paid ($0.88 divided by 4 times a year = $0.22 per share quarterly dividend). Before she enrolled in Coca-Cola’s dividend reinvestment plan, Jane would normally receive a cash deposit of $220 in her brokerage account. This quarter, however, she logs into her brokerage account and finds she now has 1,004.40 shares of Coca-Cola. The $220 dividend that was normally paid to her was reinvested in whole and fractional shares of the company at $50 per share.

Partial Enrollment in a DRIP: Example

William Jones owns 500,000 shares of Altria group. The stock currently trades at $49.75 and pays an indicated annual dividend of $2.72 per share ($0.68 per quarter). William would like to receive some cash for living expenses but would like to enroll some of the shares in a DRIP. He calls his broker and has 300,000 shares enrolled in Altria’s DRIP.
 

When the quarterly dividend is paid, William will receive cash dividends of $136,000. He will also receive 4,100.50 additional shares of Altria Group giving him holdings of 304,100.50 shares (300,000 shares * $0.68 dividend = $204,000 divided by $49.75 per share price = 4,100.50 new shares of Altria Group).

Dividends on Dividends

Why are dividend reinvestment plans conducive to wealth building? Notice that William now has 4,100.50 additional shares of Altria stock. When the next quarterly dividend is paid, he will receive $0.68 for each of those shares. That additional income works out to $2,788.34. Those dividends will be partially reinvested in the stock, buying more shares which will pay more dividends.

 

In even the smallest portfolio, dividend reinvestment plans can result in substantial increases in value over extended periods of time. To demonstrate the power of dividend reinvestment through DRIPs, consider the example given in Jerry Edgerton and Jim Frederick’s August 1, 1997 Money magazine article, Build Your Wealth Drip by Drip: if you had put $10,000 in Standard & Poors 500 stock index at the end of 1985 and not bothered to reinvest your dividends, you would have had $29,150 by the end of 1995. Had you reinvested the dividends, however,  your total would have been more than $40,000.

 

In other words, reinvesting those seemingly small dividends resulted in an extra $10,850 over ten years. Assuming you continued to add to your principal investment and held those stocks for thirty or forty years, the difference could be hundreds of thousands of dollars or more.

More Information - Our Ultimate Guide to Dividend Investing

You're now ready to move on to our Ultimate Guide to Dividend Investing. There, you'll learn advanced dividend strategies, how to avoid dividend traps, how to use dividend yields to tell if stocks are undervalued, and much more.