What Is a Dividend: Essentials of How They Work

What is a Dividend. It seems like a simple question, but many investors don’t understand the concept and how dividends work? Some articles say dividends don’t matter. This belief is an inherently incorrect statement. Dividends matter to investors, but some investors are not clear what a dividend is. Hence, they have misconceptions about dividends. However, dividends are often a significant component of total returns, and thus investors need to know what a dividend is. The bottom line is profitable companies that are growing usually pay dividends to their shareholders. We will cover the basics and some more advanced topics about dividends.

What Is a Dividend?

Dividends are cash distributions from profits paid by companies to their investors. Thus, dividends are cash payouts to investors. Most US companies pay dividends quarterly, although some pay monthly, semi-annually, or annually. It is more common for European or Asian companies to pay dividends semi-annually or annually.

Dividends are income that investors are paid for each share of stocks that they own. For example, if Company Z pays a regular quarterly dividend of $1.00 per share and an investor owns 100 shares, they will receive $100 per quarter.

After paying a dividend, the stock price is adjusted downward by the dividend amount after the market closes. For example, suppose Company Z trades at $100 per share at market close on the date the dividend is paid. The stock price is adjusted downward to $99.00 when the market opens the next day.

The downward adjustment in stock price occurs since the dividend represents a transfer of assets from the company to the shareholder, reducing market capitalization. Therefore, this action adjusts market value downward.

Types of Dividends

There are three basic types of dividends. In the above section, we discussed regular cash dividends, the most common dividend type. There are also stock dividends and special dividends.

Regular Dividend

 A regular cash dividend is paid from earnings to shareholders. It is paid to shareholders of common stock and preferred stock. The dividend payment may not be the same for both classes of stock. Common stock shareholders have voting rights, but the dividend is not guaranteed. The company’s Board of Directors may or may not declare a dividend depending on economic circumstances.

On the other hand, preferred stock shareholders do not have voting rights. Still, the dividend is a higher priority than common stock but a lower priority than bond and creditors during bankruptcy. The dividend rate is fixed, and the dividend yield may be higher. Financial institutions often have both common stock and preferred stock.

Stock Dividend

A stock dividend is a dividend paid in the stock of the company. A stock dividend is less common than a regular cash dividend. Typically, a company that pays a stock dividend also pays a regular cash dividend.

Special Dividend

A special dividend is a dividend that is paid irregularly with cash or stock. In general, special dividends are paid with excess capital. For example, a special dividend is sometimes paid during a merger, acquisition, or divesture. Special dividends are usually much more significant in dollar value than regular cash dividends.

Important Dividend Dates

Declaration Date

The declaration date is also known as the announcement date. This date is when the company’s board announces the dividend. This information is published as a press release and includes the amount, the record date, and the payment date.

Ex-Dividend Date

The ex-dividend date is the day when dividend eligibility expires. To receive the dividend, a shareholder must own the stock before the ex-dividend date. This date is one business day before the record date. If investors buy the stock on the ex-dividend, they cannot receive the dividend payment. Instead, the dividend is paid to the seller if an investor buys a stock on the ex-dividend date. The one day between the ex-dividend and record date gives companies and brokerages time to update records. The ex-dividend date is set by the US Securities and Exchange Commission (SEC).

Record Date

The record date is when the company must have a shareholder listed to receive the recently announced dividend. If the company does not have the investor recorded as a shareholder, they will not receive the dividend payment.

Payment Date

The payment date is when the company pays the dividend to shareholders recorded on the record date. In general, the payment date is two to four weeks after the record date but can be longer.

Real World Example

Let us use Stepan Company’s (SCL) recent dividend increase announcement as an example. Stepan’s Board of Directors declared a $0.335 per share quarterly dividend on October 19. The ex-dividend date is November 29, about one month later. The record date is November 30. The payment date is December 15. This announcement was the 54th consecutive annual increase for the Dividend King. The new dividend was a 9.8% increase from the prior dividend.

The table below illustrates Stepan’s dividend declarations, record, ex-dividend, and payment dates for the past two years taken from Portfolio Insight*.

Declaration Date	Ex-Dividend Date	Record Date	Payment Date
October 19, 2021	November 29, 2021	November 30, 2021	December 15, 2021
July 27, 2021	August 30, 2021	August 31, 2021	September 15, 2021
April 26, 2021	May 27, 2021	May 28, 2021	June 15, 2021
February 18, 2021	March 4, 2021	March 5, 2021	March 15, 2021
October 21, 2020	November 27, 2020	November 30, 2020	December 15, 2020
July 22, 2020	August 28, 2020	August 31, 2020	September 15, 2020
April 21, 2020	May 28, 2020	May 29, 2020	June 15, 2020
February 4, 2020	March 4, 2020	March 5, 2020	March 15, 2020

Why Companies Pay Dividends

Why do some companies pay dividends, and some do not? There are over 6,000 publicly traded stocks on US stock exchanges. A majority of US stock exchanges pay dividends. In the S&P 500, about 84% of the stocks currently pay dividends. Internationally, around 61% of stocks pay dividends.

In general, large, relatively stable companies pay dividends. However, dividends are more common in specific industries, such as consumer staples, utilities, telecommunications, energy, financials, healthcare, and aerospace & defense.

Some types of companies must pay dividends. For example, real estate investment trusts (REITs) must pay 90% of their taxable income as dividends each year to avoid paying federal income tax. Master limited partnerships (MLPs) must also pay distributions, a type of dividend. MLPs are pipeline companies. Both REITs and MLPs are pass-through entities meaning they pass-through income, cash flow, and tax obligations to shareholders.

Companies pay dividends to reward shareholders. Certain investors like retirees or dividend growth investors prefer to invest in stocks with dividends. Dividends generate a passive income stream. It is important to remember that total return equals the sum of price appreciation, dividend yield, and expansion or contract of the price-to-earnings (P/E) ratio. Hence, the dividend is one of the three components of investor returns. Dividends have provided a significant percentage of total return for stocks in the S&P 500.

Why Companies Don’t Pay Dividends

Some companies don’t pay dividends. Unfortunately, there are many examples of large and small companies that do not pay dividends. For example, Amazon (AMZN) and Tesla (TSLA) do not pay dividends.

Dividends are paid from free cash flow, paid after expenses and capital expenditures (CAPEX). A rapidly growing company may use a high percentage of its operating cash flow (OCF) to fund future growth. Free cash flow can also be used to pay down debt and deleverage or share buybacks. Lastly, free cash flow can be used to pay for acquisitions. Hence, there are multiple other uses for free cash flow besides paying dividends. Companies will set priorities, and dividend payments to shareholders may not be a top one.

Taxes on Dividends

Dividends are taxed when paid since the IRS views them as income. This fact is the case even if an investor reinvests the dividends through a dividend reinvestment plan (DRIP) into the same stock. However, dividend tax rates differ depending on whether they are qualified or non-qualified. Non-qualified dividends are also referred to as ordinary dividends. A company usually issues a Form 1099-DIV stating the dollar amount of your dividends and if they are qualified or not.

Qualified dividends are taxed at the lower long-term capital gains tax rate, while non-qualified dividends are taxed at the higher regular income tax rate. This difference makes qualified dividend tax efficient. For example, the tax rate on qualified dividends is 0% if you are a joint filer with a household income of $75,000. The tax rate on regular income is 12%. The difference between qualified and non-qualified dividends is more significant at higher income tax brackets.

The IRS website has more information about how dividends are taxed.

Qualified Dividends

Qualified dividends must meet specific requirements.

• The dividend must be paid by a US company of a company in US possession.
• Second, the dividend can be paid by a foreign company residing in a country eligible for benefits under a US tax treaty.
• Third, the dividend can be paid by a foreign company that can be easily traded on a major U.S. stock market.
• Lastly, the stock must have been held for more than 60 days during the 121 days beginning 60 days before the ex-dividend date.

You should receive a Form 1099-DIV from your brokerage that states whether a dividend is qualified or ordinary. If you own shares in an MLP partnership, your dividend will be reported on a Schedule K-1.

Important Financial Literacy Terms for Dividends

There are more financial literacy terms that investors should know and understand.

Dividend Rate

The dividend rate is the dividends per share in a year. In our example above, Company Z paid a quarterly dividend of $1.00 per share. Hence, the annual dividend rate is $4.00 per share. In addition, the dividend rate can be used to determine valuation employing the Gordon Growth Model.

Dividend Reinvestment Plan

DRIP is a plan permitting the shareholders to reinvest the dividends paid to them in the same company’s stock. Many investors take advantage of DRIP investing to follow a dividend growth strategy. An investor can receive fractional shares if the dollar amount of the dividend is insufficient for a whole number of shares. In addition, DRIP investing is often commission-free.

Dividend Yield

The dividend yield is the annual dividend per share divided by the current stock price expressed as a percentage. The dividend yield is a component of the total return to the investors. For example, suppose you buy a stock with a dividend yield of 3%; your total return is 3% plus price appreciation plus P/E ratio expansion or contraction. The dividend yield is inversely related to stock price, and thus it is used as a valuation metric. Suppose the stock price goes down, then the dividend yield must go up. Dividend yield is calculated by a simple formula.

The Dividend Yield Formula

Dividend Yield = Annual Dividend Per Share / Current Stock Price

Payout Ratio

The payout ratio is the annual dividend per share ratio to annual earnings per share expressed as a percentage. A payout ratio of more than 100% indicates a company is paying out more than it earns in dividends. The dividend payout ratio is calculated easily.

Dividend Payout Ratio Formula

Dividend Payout Ratio = Annual Dividend Per Share / Annual Earnings Per Share

Can You Live Off Dividend Income?

Can you live off dividends? The answer to this question depends significantly on the individual investor. If their cash flow requirements are high, dividends are probably one component of passive income. However, creating a high passive income stream is challenging unless the investor has sufficient capital.

For example, suppose the desired dividend income is $40,000 per year. In this case, an investor would need about $1.2 million at a 3% dividend yield to achieve that income. Unfortunately, most retirees do not have that much net worth. However, it is possible to get to a $40,000 annual dividend income using a dividend growth investing strategy and sufficient time.

The Bottom Line

Dividends require cash, and companies performing poorly often cut, suspend, or freeze their dividends. Monthly dividend statistics indicate that dividends are decreased or omitted during economic recessions at a greater rate than dividend increases or reinstatements. The opposite is also true. Dividends are increased or reinstated at a greater rate than decreased or omitted during periods of economic growth.

Next, dividends are an essential aspect of understanding stocks. Lastly, dividends have historically provided a significant percentage of total return. Some studies have also shown that dividend growth stocks and dividend-paying stocks have lower volatility. In addition, qualified dividends are tax-efficient. Lastly, dividends are an indicator of a company’s health. For these reasons, investors should strongly consider investing in dividend stocks.

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