Take a quick dive into the basics of dividends including how they work, when they're paid, and why companies share profits with stockholders.
Watch video: Dividend Basics
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Narrator: A dividend is a payment shareholders receive from a company's earnings. When a company is profitable, management can choose to reinvest profits to help grow the business or distribute those profits to shareholders in the form of dividends.
Dividends come in several forms, but the most common is cash, which is deposited into shareholders' investment accounts. For example, if a company declares a $0.30 dividend and you own 100 shares, you'll receive $30.
Typically, mature companies with strong cash flows are more likely to pay dividends. Many investors seek the income associated with dividends and often view them as a sign of strength and positive expectations for future earnings.
Companies often pay dividends quarterly; however, some pay semiannually or annually. Keep in mind, companies aren't obligated to pay a dividend and can reduce or stop paying it at any time.
You should also be aware that simply owning a stock on the day its dividend is paid doesn't necessarily mean you'll receive the dividend.
You must be a shareholder earlier, on what's called the record date. There is a cut-off prior to the record date called the ex-dividend date. Those who buy the stock on or after the ex-dividend date are not eligible to receive the upcoming dividend. The important thing to remember is that you typically need to purchase a stock at least a couple days before the record date to officially own it in time to be eligible to receive the dividend.
The number of days between the record date and the day the dividend is paid varies from company to company but is often between one and six weeks.
Instead of receiving dividends as cash, you can also opt for an automatic dividend reinvestment plan, or DRIP, for eligible securities. With a DRIP, dividends are automatically used to purchase additional shares. This allows investors to accumulate more shares over time and can potentially compound returns but also increases portfolio risk.
Some investors specifically seek out and invest in dividend-paying stocks. Dividend stocks can provide income and potentially enhance a portfolio's overall returns.
Animation: Chart shows the contribution of dividends to S&P 500 ® Index Total Return and price appreciation from 1926 to 2019. The chart shows that dividends provide income even in years where the index fund may have lost value.
On-screen text: Source: 2019 Stocks, Bonds, Bills & Inflation ® (SBBI ® ) Yearbook (1926-2018); Bloomberg (2019-2021). 1
Narrator: Since 1926, the U.S. economy has undergone many bull and bear market cycles. However, the income return received from dividends has been relatively consistent during this time period.
Investors can measure the percentage return from dividend income using dividend yield. Yield is the percent return of an asset paid over one year. For dividend stocks, the yield is the sum of the last four quarterly dividends divided by the price of the stock multiplied by 100. Let's look at an example. Say there's a $30 stock that over the past four quarters paid dividends totaling $0.78 per share. This means the stock has dividend yield of 2.6%.
Dividend yield essentially tells you how much return you're getting for the price of the stock. It also allows you to compare the dividends of stocks with different prices, as well as other interest-bearing securities, like bonds or CDs.
Many investors look for consistent and growing dividends over time as an indication of company health and likelihood of paying future dividends.
Although dividend stocks have many benefits, they do have some unique risks. Because they're often considered an alternative to interest-paying securities, dividend stocks are vulnerable to changes in interest rates. In a rising rate environment, investors might sell dividend stocks and shift money into other securities yielding a higher return.
It's also important to remember that dividends aren't guaranteed. Companies that pay unusually high dividends may not be able to sustain them, and if dividends are cut, it might send the stock price tumbling.
Despite these risks, dividend-paying stocks tend to provide income while still allowing for the potential of stock price appreciation.
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