Dividend Stocks & How They Work
This post will try to help you understand what dividend stocks are, how they work, as well as how you can get started with your own stock trading.
How do stock dividends work?
A dividend stock is a stock that will pay you per share you have in the company. For example, if you own 30 shares in a company, and that company pays $3 in annual dividends, you will earn $90 per year from your stock. Companies generally pay dividends as cash, this cash will normally be deposited to the shareholder’s brokerage account. Some companies however will pay dividends in new shares of stocks instead.
Some companies will also offer dividend reinvestment programs, these programs are called DRIPs. A program like this will allow investors to reinvest the dividend back into the company’s stock, often at a discounted price. This means that over time you can easily grow your stock portfolio and can provide excellent long term investment opportunities.
How often are dividends paid?
This depends, however, usually in the United States companies will pay dividends on a quarterly basis. Dividends can sometimes be paid monthly, or semi-annually, you will need to check the specific stock you are looking at to see their specific payout terms.
A companies board of directors must first approve each dividend payout, then the company will announce when the dividend will be paid, the amount of the dividend, and the ex-dividend date.
The ex-dividend date is very important to investors, this is because investors must own stock by this date in order to receive the dividend. Investors who purchase dividend stocks after this date will not be eligible for a dividend payout.
What is a dividend yield?
The dividend yield is a number given as a percentage, to explain further we will have to jump into some specifics.
Financial websites and online brokers will often report a companies dividend yield, this number is a measure of the company’s annual dividend, divided by the stock price on a specific date.
The dividend yield makes more accurate comparisons of dividend stocks possible. For example, a $20 stock paying $0.20 quarterly ($0.80 per share annually) has the same dividend yield as a $100 stock that pays $1.00 quarterly ($4.00 annually). The dividend yield in both of these cases would be 4%.
Dividend yield and stock prices are inversely related. In basic terms, when one goes down the other goes up. So with that in mind, there are two ways for a stock’s dividend yield to go up:
- The company could raise its dividend price. A $100 stock with a $4 annual dividend might see a 10% increase to its dividend. This will raise the annual payout to $4.40 per share. If the price of the stock does not change, then the yield will become 4.4%
- The stock price could go down while the dividend remains unchanged. The same $100 stock with a $4 annual dividend might lose value, becoming $90 per share. This would mean you now have a stock worth $90, with a dividend payout of $4, meaning the dividend yield would have raised from 4% to 4.4%
FOR MOST STOCK, A YIELD ABOVE 4% SHOULD BE SCRUTINIZED. THIS RATE OF DIVIDEND YIELD COULD INDICATE THAT THE DIVIDEND PAYOUT IS UNSUSTAINABLE!
There are however some exceptions to the 4% rule. For example stock sectors that have been created to pay dividends, this includes real estate investment trusts. It is not too unusual for REITs to pay safe yields that are in the 5% to 6% dividend yield, and still be in a position to grow.
What is a dividend payout ratio?
A quick way to measure the safety of a dividend is to check the payout ratio. This is the portion of its net income that goes towards dividend payouts. If a company pays 100% or more of its income, this is an easy way to see if the dividend might be in trouble. During harder economic times, earnings may take a dip which will result in income that is too low to cover dividends. Generally, investors look out for payout ratios that are 80% or lower. Just like stock dividend yield, a company’s payout ratio will be listed on almost all brokerage websites.
Types of dividends
One of the most common types of dividends are dividends that are paid on a company’s common stock. There are however two other types of dividend stocks that occur less regularly.
- A special dividend is a payout on all shares in a company’s common stock, this however doesn’t recur on a schedule like regular dividends. A company will often issue a special dividend to distribute profits that have accumulated over several years. This money will be paid during a time when the company has no immediate need for this cash.
- A preferred dividend is issued to owners of preferred stocks. Preferred stocks are stocks that function more like bonds, usually with a fixed quarterly payment. Unlike dividends on the common stock, a dividend on preferred stock is generally fixed.
Stocks that pay dividends
Stocks that pay dividends can easily provide a stable and growing income for you. Investors typically prefer to invest in companies that offer dividends that increase year after year, this helps the investors dividend to outpace inflation rates.
Dividends are more likely to be paid from well-established companies that do not need to reinvest as much money back into their company. High growth, tech, and biotech companies for example rarely pay dividends, this is because usually, they need all of this money to reinvest into expanding and growing their business.
If a company has established or raised a dividend, investors usually expect it to be maintained, even during tough economic times. The most reliable American companies have a record of growing dividends, with no cuts for decades. Investors often will devalue a stock if they think the dividend will be reduced, this leads to a lower share price.
Some examples of American companies that pay dividends include Target, CVS, Disney, Exxon, and CocaCola.
To get started with your own stock trading, read our guide on trading dividend stocks.