What is a Stock Dividend?
A dividend is a cash payment from a company’s profits paid to shareholders monthly or quarterly. Dividends are a great way for investors to be rewarded with cash bonuses while waiting for stock prices to appreciate. Most dividends are paid in cash, however some companies offer stock dividends.
As an example, if a corporation pays a cash dividend of 50 cents a share, an investor with 500 shares will receive $250 in dividends which is directly deposited in to their brokerage account.
Please be aware that dividends are not guaranteed. The board of directors of a public company meet on a monthly or quarterly basis to decide whether they will pay a cash dividend or not. Dividends are not like bonds that have a guaranteed interest, also known as “coupon.”
Why Should You Invest in Dividend Paying Stocks?
Why do people invest in dividend stocks? Reason is for their stable cash flows. Retirees can use these cash payments to supplement their living expenses each month.
Younger investors on the other hand can “re-invest” these dividends to buy more shares, which in turn will pay growing dividend checks each month. This is known as the dividend growth investing strategy.
In fact, according to data from the S&P 500 and Dow Jones Indices, the S&P 500 has achieved annual average gains of 7.43% in the last 50 years. This does not include dividends.
However, with dividends reinvested, the average annual gains were 10.55%. For most investors, an extra 3% return over long periods of time really buildings long lasting, compounding wealth.
Why Do Some Stocks Pay Dividends While Others Don’t?
Reason for this is nature and maturity of their underlying business. Dividends are a signal to shareholders that the underlying cash flows of a corporation are strong and recurring in nature, and their going-concern principle is not in doubt.
Dividends are paid after a company pays its operating expenses and capital expenditures. Since mature corporations already have a competitive moat or “fortress” around their business, they will not need to invest as much money as a younger start up that has huge room for growth.
Small startups use 100% of their free cash flow to reinvest in building their products, building inventories for increased demand, research and development, and to hire talented employees.
There are 57 companies that have not only paid dividends for 25+ consecutive years, but also grown them every year. Read about these stocks in our tutorial on dividend aristocrats.
How Do Companies Pay Dividends?
It should be easy to collect dividends right? After all, you buy a stock and the money is deposited in to your brokerage account every quarter. Yes, this is correct in most parts however there is an underlying process that occurs. Here we break it down.
There are 4 important dates to consider when expecting to collect a dividend.
- Dividend Declaration Date
- Ex-Dividend Date
- Record Date
- Payment Date
Step #1: Board of Directors declares a dividend. This is the dividend declaration date. This is usually a press release that is posted on the company’s Investor Relations website.
Step #2: Next, the company has to decide who gets the dividend. It does so via the ex-dividend date. Investors who hold shares the day before the ex-dividend date are eligible to receive the dividend.
Important: Investors who buy the stock on or after the ex-dividend date are NOT eligible to receive the dividend.
Step #3: Next, the Record date is when the corporation looks at its books to see who should receive the dividend.
Step #4: Payment date is pretty straightforward; it is the date when the cash is deposited in to investors’ brokerage account.
Dividend Re-Investment Plans
Some corporations allow their investors to buy more shares with their cash dividends, which includes even fraction of shares at no extra cost or fees. This popular method is known as the dividend reinvestment plan (DRIP). Advantages of enrolling a DRIP are:
- Enrollment is very easy, just instruct your brokerage account to re-invest all dividends.
- Cash dividends are automatically re-invested on the payment date to buy more shares. This process is entirely automated and does not require maintenance.
- DRIP purchases do not contain costs like brokerage or transaction fees.
- Investors can use DRIP method to take advantage of compounding to build long term wealth.
- Examples of companies that offer DRIP programs include 3M, Sherwin Williams, Exxon Mobil, Honeywell and Johnson & Johnson.
DRIP Enrollment Example
Abby is a young investor who recently purchased 150 shares of JP Morgan Chase at a cost of $133 per share, making a total initial investment of $20,000. At the end of 1st quarter, JP Morgan Chase declares a dividend of $0.90 per share. On the payment date, Abby receives 1 share of JPM. She now owns 151 shares of this company.
How did the Math work? Well at $0.90 per share in dividends, Abby would otherwise receive a cash dividend of $0.9 x 150 shares = $135. Since this money is re-invested in buying additional shares, she would get 1 share at a cost of $133 and an additional $2 in fractional shares.
What is the Dividend Payout Ratio?
Dividend payout ratio is the % of profits the company pays to shareholders in the form of cash dividends. The reason investors should pay attention to this metric is to ensure a corporation pays dividends via free cash flow generated from the underlying business, and that it is sustainable.
Dividends that are paid as a result of issuing debt or stock, or a one time litigation win is usually not sustainable. However, cash left over after paying all operating and capital expenses is a strong candidate for dividends.
How do you calculate the dividend payout ratio? In JP Morgan Chase’s 2018 annual report, management reports net income per share of $9.04 for the full year. Cash dividends declared in the year equal $2.72. What is the payout ratio?
Dividend Payout Ratio = Cash Dividends Declared $2.72 / Net Income per Share $9.04
Dividend Payout Ratio = 30%
This means JP Morgan Chase paid 30% of its net profits to shareholders in the form of cash dividends. This is a very healthy number leaving the remaining 70% of profits for capital expenses, acquisitions, stock repurchases or hiring more employees to expand operations.
What is the Dividend Yield?
The dividend yield measures the ratio of a company’s annual cash dividends divided by its current share price.
As an example, JP Morgan Chase has paid $0.90 quarterly dividends over the last 1 year. In annualized terms, this equals $3.60 total dividends. As of January 2020, JPM’s Stock price is $133. What is the dividend yield?
Therefore, JP Morgan Chase currently pays a 2.7% dividend yield. As a comparison, the S&P 500 Index pays a 1.8% dividend yield.
What is a Special Dividend?
A special dividend, as its name suggests, is a one-time non-recurring dividend paid to shareholders. Some of the reasons include excess cash on the balance sheet that the company does not reinvest in the business, a major litigation win or a business spin-off.
An example of a popular special dividend was in July 2004 when Microsoft announced a $3 dividend per share totaling $32 billion in total payout to shareholders. At the time, Microsoft had a staggering $50 billion in cash.