Dividends are a method of distributing a company's earnings to shareholders of their stock. These dividends may take one of several forms:
- Stock Dividends - The allocation of extra shares of stock. New stock is created and distributed to shareholders as a percentage of their current holdings. While you hold more stock now, it's a short-term wash because the price is diluted by the extra supply of stock.
A simple example: A company has 10,000 total shares selling at $50/share, so it has $500,000 in total stock value (otherwise known as market capitalization). If you hold 1% of that company's stock, you have 100 shares with $5,000 market value. If the company issues a 10% stock dividend, they print up 1,000 extra shares. The current value is divided among 11,000 shares, for a price of $45.45/share. You are issued your 1% portion (10 new shares), and you now have 110 shares at $45.45/share for the same $5,000 market value. (However, if the company’s price were on an upward trajectory, higher share prices multiplied by a greater number of shares you hold would prove beneficial.)
- Cash Dividends – A cash payout to stockholders as a percentage of their holdings. Payouts may be cash, or they may be reinvested in stock via a DRIP (Dividend Reinvestment Plan), where dividends are automatically used to purchase more stock at the current price. You may choose to reinvest all or part of a cash dividend.
- Property Dividends – Dividends paid in goods — anything from shares in a subsidiary company to physical goods such as the company's product. Not commonly used.
- Special Dividends – Usually a one-time distribution from a significant event — for example, liquidation of a major asset or sale of a subsidiary. This may be classified as "return of capital" (as if your original investment capital were returned), with a different tax classification.
Most dividends are subject to your ordinary income tax rate. Some forms of qualified dividends are subject to lower tax rates, but rules and rates have been in flux recently. Check with the IRS or a tax professional to determine the correct tax status for your dividends.
There are four important dates with respect to dividends:
- Declaration Date - The date when the Board of Directors sets the amount and timing of the next dividend. The liability is entered in the books, and the other important dates are announced.
- Date of Record - When the ownership for the stocks is verified (in other words, who receives the dividends).
- Ex-Dividend Date – The date three days in advance of the date of record. Transactions may take up to three days to be settled. During the period between the ex-dividend and dividend, stocks are sold "ex-dividend" (the price may be reduced by the amount of dividend) and the dividend is paid to the seller. Generally, it is preferable to buy stocks before the ex-dividend date (and similarly, better to sell after).
- Payout Date - When the payments are made by whatever means each stockholder has chosen.
Not all companies pay dividends (Apple was notorious for not doing so when Steve Jobs ran the company), and not all companies that pay dividends are necessarily a good investment. For a secure income stream from dividends, it is best to invest in blue-chip stocks with a proven track record of dividend payout. Good numbers for comparison are:
- Dividend Payout Ratio – The percentage of net income paid out as a dividend. This is a useful indicator of growth or stability of a company. How much of their income do they retain, and what is the likely reason why?
- Dividend Yield – The annual dividend earning divided by the price per share. A higher dividend earning is not necessarily preferable. A higher dividend yield means that the stock pays out a greater percentage of their value as a dividend, thus it is a better return for your investment dollar.
Looking at past dividend history is useful, but beware of time lags in bad economic results and the effect on the books. You may buy a stock expecting a dividend that never comes because the Board of Directors is holding back cash for upcoming hard times or a major event like an acquisition.
In summary: when considering the impact of dividends on your selection of a stock, assess the payout ratios, dividend yield, and dividend history. You should also monitor the important dividend dates to make sure you buy your stock at the proper time. Experts say you can’t time the market, but you should when it comes to these crucial dates!