A cash dividend is money paid to stockholders, normally out of the corporation's current earnings or accumulated profits. Not all companies pay a dividend. Usually, the board of directors determines if a dividend is desirable for their particular company based upon various financial and economic factors. Dividends are commonly paid in the form of cash distributions to the shareholders on a monthly, quarterly or yearly basis. All dividends are taxable as income to the recipients.
Dividends are normally paid on a per-share basis. If you own 100 shares of the ABC Corporation, the 100 shares is your basis for dividend distribution. Assume for the moment that ABC Corporation was purchased at $100/share, which implies a $10,000 total investment. Profits at the ABC Corporation were unusually high so the board of directors agrees to pay its shareholder $10 per share annually in the form of a cash dividend. So, as an owner of ABC Corporation for a year, your continued investment in ABC Corp should give us $1,000 in dividend dollars. The annual yield is the total dividend amount ($1,000) divided by the cost of the stock ($10,000) which gives us in percentage terms, 10%. If the 100 shares of ABC Corporation were purchased at $200 per share, the yield would drop to 5%, since 100 shares now cost $20,000, or your original $10,000 only gets you 50 shares instead of 100. If the price of the stock moves higher, then dividend yield drops and vice versa.
The Mechanics of Dividends
Do dividend-paying stocks make a good overall investment? Dividends are derived from a company's profits, so it is fair to assume that dividends are generally a sign of financial health. From an investment strategy perspective, buying established companies with a history of good dividends adds stability to a portfolio. Your $10,000 investment in ABC Corporation, if held for one year, will be worth $11,000, assuming the stock price after one year is unchanged. Moreover, if ABC Corporation is trading at $90 share a year after you purchased for $100 a share, your total investment after receiving dividends still breaks even ($9,000 stock value + $1,000 in dividends).
Herein lies the appeal to buying stocks with dividends: they help cushion declines in actual stock prices, and they also present an opportunity for stock price appreciation coupled with the steady stream of income that dividends provide.
This is why many investing legends such as John Bogle, Warren Buffett and Benjamin Graham all espouse the virtues of buying stocks that pay a dividend as a critical part of the investment return of an asset. (Discover the issues that complicate these payouts for investors Dividend Facts You May Not Know.)
Risks to Dividends
During the financial meltdown in 2008-2009, all of the major banks either slashed or eliminated their dividend payouts. These companies were known for consistent, stable dividend payouts each quarter for hundreds of years, yet despite their storied history, the dividends were cut.
The lesson is that dividends are not guaranteed and are subject to macroeconomic as well as company-specific risks. Another potential downside to investing in dividend-paying stocks is that companies that pay dividends are not usually high growth leaders. There are a few exceptions, but high-growth companies usually do not pay dividends to shareholders even if they have significantly outperformed over the vast majority of all stocks over the last five years. Growth companies tend to spend more dollars on research and development, capital expansion, retaining talented employees and/or mergers and acquisitions, which leaves them with little to no money to spend on dividends.
For these companies, all earnings are considered retained earnings and are reinvested back into the company instead of rewarding loyal shareholders.
It is equally important to beware of companies with extraordinarily high yields. As we have learned, if a company's stock price continues to decline, its yield goes up. Many rookie investors get teased into purchasing a stock just on the basis of a potential juicy dividend. However, there is no specific rule of thumb in relation to how much is too much in terms of a dividend payout.
The average dividend yield on the S&P 500 companies that pay a dividend historically fluctuates somewhere between 2-5%, depending on market conditions. In general, it pays to do your homework on stocks yielding more than 8% to find out what is truly going on with the company. Doing this due diligence will help you decipher those companies that are truly in financial shambles from those that are temporarily out of favor and therefore present a good investment. (To read more on this subject, see Why Dividends Matter, How Dividends Work For Investors and 6 Common Misconceptions About Dividends.)
How Companies Pay Dividends
Dividend payouts follow a set procedure. To understand it, first we'll define the following terms:
1. Declaration Date
The declaration date is the day the company's board of directors announces approval of the dividend payment.
2. Ex-Dividend Date
The ex-dividend date is the date on which investors are cut off from receiving a dividend. If, for example, an investor purchases a stock on the ex-dividend date, that investor will not receive the dividend. This date is two business days before the holder-of-record date.
The ex-dividend date is important because from this date forward, new stockholders will not receive the dividend, and the stock price reflects this fact. For example, on and after the ex-dividend date, a stock usually trades at a lower price as the stock price adjusts for the dividend that the new holder will not receive.
3. Holder-of-Record Date
The holder-of-record (owner-of-record) date is the date on which the stockholders who are eligible to receive the dividend are recognized.
(Understanding the dates of the dividend payout process can be tricky. We clear up the confusion in Declaration, Ex-Dividend and Record Date Defined.)
4. Payment Date
Last is the payment date, the date on which the actual dividend is paid out to the stockholders of record.
Example: Dividend Payment
Suppose Newco would like to pay a dividend to its shareholders. The company would proceed as follows:
1. On Jan. 28, the company declares it will pay its regular dividend of $0.30 per share to holders of record as of Feb. 27, with payment on Mar. 17.
2. The ex-dividend date is Feb. 23 (usually four days before of the holder-of-record date). As of Feb. 23, new buyers do not have a right to the dividend.
3. At the close of business on Feb. 27, all holders of Newco's stock are recorded, and those holders will receive the dividend.
4. On Mar. 17, the payment date, Newco mails the dividend checks to the holders of record.