What are Dividends?
A dividend is a portion of a companies revenue that are determined by the company’s quarterly dividend yield to their share price. Ok, what does that does mean?
A dividend is money that comes from the revenue a company makes. Dividends are payed out to shareholders (people who own stock in a company) on a (usually) quarterly basis.
For example, lets say a company has a $40 stock price with a dividend yield of 2.5% that pays out on a quarterly basis. You own 100 shares of that company’s stock. So every four months, you will receive a .625% dividend of every share you own.
Let’s find out how much money from dividends you would receive the first quarter.
Shares you own: 100
Price per Share: $40
Dividend Yield: 2.5%
100 * $40 = $4,000 (How much money you invested into the stock)
$4,000 * 2.5% = $100 (How much money you received the first year)
So you would receive $100 from your dividends just from holding stock in that company. Pretty cool, right?
Dividends can be paid in cash or the cash reinvested into shares in that company. When dividend earnings are automatically reinvested into stock through a broker, it is commonly referred to as a DRIP (dividend reinvestment plan).
I highly recommend using a DRIP when you invest.
Why do companies pay dividends?
After you ask “what are dividends,” the next question you may ask is “why do companies pay dividends?”
Companies pay out dividends to shareholders for several reasons.
- Dividends attract more investors to invest in your company.
- Dividends encourage investors to keep their investment in the company
- Dividends can give the impression that your company is liquid and growing
- To compete with other dividend holding companies
But sometimes dividends are viewed differently.
Different Dividend Theories
Dividends are seen as controversial as to how we should look at the company it self. Let me show you what i’m talking about.
These are the different dividend theories pertaining to the value of a firm. This one you may have heard about before.
Dividend Irrelevance Theory
If you ever studied finance in college, you’ve probably heard of Modigliani and Miller. Modigliani and Miller were 2 professors from the 1950’s that created a theory on the irrelevance of capital structure. They stated that the valuation of a firm is irrelevant to the capital structure of a company.
Modigliani and Miller claim that a company’s dividend policy has no effect to the value of a company. Dividends have no effect on the share price of a firm, and should be viewed the same as capital investments when considering ROI (return on investment).
So investors do not need to worry about dividends when considering purchasing a stock. Dividends are irrelevant.
But this theory is based on several assumptions. Assumptions such as living in a perfect capital market and dividends are taxed the same as capital gains. This model has been criticized because of its unrealistic assumptions on how financial markets operate.
How investors interpret dividend stocks vary from investor to investor.
Investors who like dividends –
These investors like dividends because they feel it’s a safer investment. These investors typically hold shares in stocks for a longer duration of time. They like use DRIP to their advantage or take just the cash. Even if they don’t go long, they see the dividend as an incentive to buy.
When a stock offers dividends, investors see these stocks as more valuable. Not only will you earn capital gains, but you will earn dividends on top of that
Investors who do not like dividends –
These kind of investors either see a company offering dividends as cry for help financially, or the stock has less volatility.
Companies sometimes offer dividends as a way to financially help out the company. The more shares a company sells, the more money back in their pockets.
Dividend stocks tend to be less volatile. If a investor wants high capital gains, dividend stocks might hold them back.
Dividends are taxed at a higher percentage compared to capital gains. Nobody likes higher taxes.
Investors who do not care either way
Then we have the investors who do not care if a stock offers dividends or not. They believe the stock will grow or fall to their advantage.
“Dividends are nice, but i’m here for the capital gains!”
How Do Dividends Effect Stock Prices?
In theory, every time a dividend is paid, the stock price decreases by the amount paid out by dividend.
What most likely happens is that if a company has earned more money than the amount they pay out in dividends, their stock price will increase. But when considering long term effects, dividends have very little to no affect on how a stock price is determined.
Stock prices are mostly determined by a companies earnings.
Since many people don’t know what are dividends, lets talk about dividend yield for a second. Dividend yield is not a continuous payment of a invariable dividend percentage.
In the same year you may receive dividends at .50 one quarter, .50 one quarter, .60 another quarter, and .75 the last quarter. The dividend yield adds up all your dividend payments from that year and divides it by the share price.
Lets calculate our dividend yield. Say the share price is $40. From the formula we see:
We add up all of our dividends to get $2.35 Divide it by our share price, $40
And multiply our answer by 100%
This will leave you with your dividend yield, 5.875%.
To be frank, 5.875% is a great dividend yield!
Different Dividend Dates
The different dividend dates you should know to understand dividends are the declaration date, record date, ex-dividend date, and payment date.
The declaration date is the date the dividend is announced. This is when a dividend becomes “real”. You know how much the dividend pays, the record date, and the payment date.
The record date is the last day you have to buy a stock to receive the upcoming dividend. This is the day the company puts records the amount of shareholders in its books. They have to know how much they payout and where the dividends are going.
Sorry, the ex-dividend date is the “past-due” date for stocks. If you bought a stock on or after the ex-dividend date you have to wait until the next declaration and payment date to receive a dividend.
If you hear a stock is going “Ex” tomorrow, you better buy some shares today if you want that dividend!
This is the day the company pays out the dividend. As long as the shares were purchased before the ex-dividend date and they were held until the payment date you will be paid a dividend.
Keep in mind that dividends can take a couple of days to show up in your brokerage account. If they do not show up after a week, you may want to call the customer service of the brokerage account.
Are Dividends Guaranteed?
Dividends are not guaranteed!
Not every stock that pays a dividend is guaranteed to pay dividends. Stocks that do pay dividends have every right to stop paying dividends at any time.
Whenever stocks decide to cease payments on dividends, that stock usually drops a significant percentage.
Dividends are only guaranteed once a company declares a dividend. A declaration date legally binds the company to payout dividends to its shareholders.
Investing with DRIP
Investing with dividends is one of the few times compound interest actually works in your favor. But how does a DRIP work in my favor? Should I just take the cash instead?
If you need the cash paid out through dividends, take the cash. If not, sign up for a DRIP.
As stated before, DRIP automatically reinvests dividends back into your shares. So instead of receiving $100 in cash, you will receive $100 worth of shares.
If the dividends you receive is less than a share you will receive a percentage of a share equivalent to the amount received in a dividend.
DRIP works in your favor by increasing the amount you receive in dividends, capital gains by percentage, and amount of shares you hold in that company.
Two people buy 50 shares of stock and hold it for 10 years. The price per share was $50 when they bought it and it’s the same price 10 years later. This means they did not have any capital gains.
But they received a constant quarterly dividend of $.5 (4% dividend yield).
Bobby had a DRIP and Shaun received cash dividends. This is the amount each portfolio is worth.
10 Years of Dividends
Bobby who had drip earned 222 more dollars than Shaun. But they both earned at least $1,000 dollars by owning a dividend stock.
Imagine the same scenario but this time they held their shares in that stock for 20 years instead of 10. The stock stayed the same with no capital gains. Let’s see how much money they earned with their dividends.
Within 20 years, Bobby has earned over $3,000 because of his DRIP. Shaun has earned his money back at only $2,000 profit. Bobby has earned over $1,000 (or 50%) than Shaun.
The moral of the article is that dividends can be your best friend. They make you much more profitable. Or they can help you break even in the event of a loss.
But dividends should not be the main deciding factor when buying a stock. The main factor on why you should be buying a stock is that you believe that company will grow in terms of capital gains. A high dividend should be a plus, but as I explained before, high dividends could be deceiving and risky.