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How Do Dividends Work?

You might already know that you need to build up baskets of assets through traditional securities such as stocks, ETFs and mutual funds. You might also already know it’s a good idea to spread your risk through diversification so you can protect your assets from market volatility.

But do you know much about dividends — the hard-won results of your investing efforts? To understand dividends, you must first understand the different types of dividends available and how companies pay dividends. Once you have a good basic understanding of these, you can take advantage of the many benefits that cash dividends, property dividends, stock dividends, liquidating dividends or a mix of these can have to jazz up your portfolio.

What are Dividends?

Dividends entitle you, the shareholder, to a portion of the net profits made by a company.  Dividends are any earnings that a company you invest in shares with its shareholders, and for every share of a dividend stock that you own, you’re paid a portion of these earnings. Dividends can come in the form of money (cash), stocks and assets.

A company needs to be in good standing to declare dividends, and the company’s board of directors also has to approve dividends each time they are paid. To do so, they go through a three-step process, which consists of:

Step 1: Declaration Date

The declaration date is the day that a board of directors issues a press release stating its intention to pay a dividend. Along with a declaration date, the board also announces a date of record and a payment date.

Step 2: Date of Record (Ex-Dividend Date)

The date of record marks when stockholders are entitled to the dividend payment. A stock will usually begin trading ex-dividend or ex-rights the fourth business day before the payment date. This means only the owners of the shares on or before that date will receive the dividend.

Step 3: Payment Date

The payment date is when shareholders actually receive their dividend. As a general rule, most dividends are paid on a quarterly basis, although some companies pay dividends annually. A company can sometimes declare dividends on a specific class of shares and can pay preferred shareholders or both preferred and common shareholders. Keep in mind that a company is not obligated by law to pay out dividends until it has made a formal declaration.

Why a Company Pays Dividends

Profitable companies can choose what to do with their earnings. They can either pay that profit out to shareholders, reinvest it in the business through expansion, debt reduction or share repurchases, or both. Dividends add value to the company’s stock as a way to attract new investors and increase company value.

What You can Gain from Dividends

A company’s board of directors decides what percentage of its earnings are distributed to shareholders in the form of dividends. The amount you earn from dividends depends on the kind of stock you own.

This is due to the nature of the dividend as well as payouts, which can come in different forms as well. Here are some of the various methods:

Cash Dividend

This is the most common form of dividend payout, which is in the form of a straightforward monetary payment. When you increase the number of shares you own in a company, you can multiply the dividend payouts by the amount you hold.

Property

A company can issue dividends in the form of inventory or other physical holdings. These can be computers or electronics, raw materials or even a car, depending on the company’s line of business. The larger your holding in the company, the bigger the physical asset you are going to receive.

Stocks

Dividends can also come in the form of stocks instead of cash. A couple reasons a company might do this is because a company might not have the adequate cash flow needed to provide cash dividends to shareholders or the company might want to keep its liquidity to itself.

How to Calculate Your Dividend

To calculate your stock’s dividend yield, simply divide the annual dividend by the stock’s price.

The dividend’s payout ratio is the percentage of net income paid out as a dividend. The retention ratio (the amount not paid out to shareholders in dividends), is the figure used to project growth. To calculate the payout ratio, divide the total amount of dividends paid out to shareholders by the reported net income of the company.

If you receive dividends from holding stock in a company, keep in mind that as an investor, you’ll face tax implications. Dividends are taxed as ordinary income. This means you’ll have to pay taxes on your dividend yield based on your tax bracket. However, if company prices go up, you can sell your stock at a profit and only be subject to a long-term capital gains tax.

Final Thoughts

The last thing to think about is what to do with your dividends and whether you’ll reinvest them. When you buy shares of a security, your broker typically asks whether you want dividends reinvested so you can automatically use them to buy more shares of the stocks in your portfolio. The process of doing this is called a dividend reinvestment plan (DRIP). Reinvesting dividends can offer you several benefits:

  • You automatically invest more money.
  • You don’t pay commission on a DRIP.
  • No minimum investment amount has to be met.
  • You can buy fractional shares.
  • Your investment’s growth compounds because you continually add more shares that will also eventually generate dividends of their own.

One more thing to keep in mind is that any dividends that are reinvested in a DRIP are known as “qualified” dividends. You’ll still pay taxes on them, but they’re taxed at a lower rate than regular income.

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