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How Dividends Can Reward You for Owning Stocks

Aug. 3, 2017
Investing, Investing Strategy, Investments
what are dividends
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Dividends are payments made by a company to its shareholders. The payment usually consists of cash earned from the company’s operation. It typically is paid to investors after the company has taken care of its own capital needs, such as reinvesting in its own business. Mutual funds and exchange-traded funds also pay investors dividends from their portfolio holdings.

Dividends can be an attractive form of return for investors, especially for retirees or those nearing retirement. Many investors purchase stocks only of companies that have a strong history of returning cash to shareholders.

How dividends work

In the United States, companies usually pay dividends quarterly, though some pay monthly or semi-annually. Companies generally pay it out in cash to the shareholder’s brokerage account, though some will pay in new shares of stock.

A company announces when it’s paying a dividend, the amount approved by its board of directors for distribution, and the ex-dividend date, or the day by when investors must own the stock to receive the dividend.

On the ex-dividend date, the stock exchange that lists the company’s shares subtracts the amount of the payout from the stock price before trading begins. Later, on the payout day, investors receive the dividend from the company in their brokerage accounts. If they sell the stock after that, they are still entitled to receive the dividend, because they owned the shares as of the ex-dividend date.

Financial websites will report a company’s dividend yield, which is a measure of the company’s annual dividend divided by the stock price on a certain date. The yield can be used to easily compare the dividends on stocks that are priced at different levels.

Don’t be fooled by a higher per-share dividend on a higher-priced stock. A $10 stock paying $0.10 quarterly, or $0.40 per share annually, has the same yield as a $100 stock paying $1 quarterly, or $4 annually. The yield is 4% in both cases.

Yield and stock price are inversely related: When one goes up, the other goes down. So, there are two ways for a stock’s yield to go up:

  • The company could raise its dividend. A $100 stock with a $4 dividend might see a 10% increase in its dividend, raising the annual payout to $4.40 per share. If the stock price doesn’t change, the yield becomes 4.4%.
  • The stock price could go down while the dividend remains unchanged. That $100 stock with a $4 dividend might decline to $90 per share. With that same $4 dividend, the yield would become just over 4.4%.

» MORE: Read up on how to buy stocks

The appeal of dividend investing

Dividend investing, or income investing, is very popular in the U.S., which can provide a stable and growing dividend stream. That’s no surprise: The thrill of having money deposited in your account just by owning a stock is priceless.

Investors typically prefer to invest in companies that pay safe (not likely to be cut) and rising dividends year after year, usually well-established names that no longer need to reinvest as much capital in their business. High-growth, tech or biotech companies rarely pay dividends, because they need to reinvest profits into expanding their business.

Once a company establishes or raises a dividend, investors expect it to be maintained, even in tough times. The most reliable American companies have a record of rising dividends — with no cuts — for decades. Investors often will devalue a stock when they estimate that the dividend is likely to be cut.

One of the quickest ways to measure a dividend’s safety is to check its payout ratio, or the portion of its net income that goes toward dividend payments. If a company pays out nearly 100% or even more of its income, the dividend could be in trouble. During tougher times, earnings might dip too low to cover dividends.

What level of dividends can investors expect?

In the wake of the financial crisis and with many Americans retiring and needing regular income, the price of stocks have gone up, lowering their dividend yields.

For most stocks, anything above a 4% yield should be carefully analyzed, lest investors buy a stock with an unsustainable dividend.

However, there are some exceptions to this 4% rule — specific stock sectors that were created to pay dividends, including real estate investments trusts (REITs) and master limited partnerships. It’s not unusual for companies in those sectors to pay safe yields in the 5% to 6% range and still have growth potential.

A safe dividend sounds great, but investors pay a lot for (the perception of) safety. While a low yield implies a safe dividend, it can also imply an overvalued stock. If investors buy a low-yield stock thinking it’s safe, they can be stung in two ways: with a low yield and with potential downside in value, if the stock price should fall.

» MORE: Ways to minimize capital gains taxes on dividends

So what can an investor do?

For many, the alternative to buying high-yielding stocks is what’s called dividend growth investing. Investors search for healthy companies that can grow their payouts for years or decades.

It’s not unusual for some of the best companies to increase dividends by 8% to 10% annually for years on end. This approach can be an attractive complement to the traditional buy-and-hold investing way.

Other types of dividends

This article has covered the most usual type of dividends, which are those paid on a company’s common stock. There are two other types of dividends, which occur infrequently.

A special dividend is a payout on all shares of a company’s common stock, but it doesn’t recur like a regular dividend. A company often issues a special dividend to distribute profits that have accumulated over several years and for which it has no immediate need.

The other type is a preferred dividend. In addition to common stock, companies can issue what’s called preferred stock. That’s a fancy term for a security that functions less like a stock and more like a bond, usually with fixed quarterly payments. Unlike dividends on common stock, dividends on preferred stock typically have no ability to grow over time as the company expands, so investors’ potential gain is limited to the dividend.

More on investing

James F. Royal, Ph.D., is a staff writer at NerdWallet, a personal finance website. Email: jroyal@nerdwallet.com Twitter: @JimRoyalPhD