One of the biggest problems faced by the new investor, or those attempting to control their own portfolio for the first time, is that the financial world is full of jargon. A cynic would say that this is deliberate; the Wall Street elite have an obvious interest in baffling you with verbiage. I don’t believe it is, but the fact remains that many of the concepts fundamental to investing go unexplained. Dividends would be a case in point. Hopefully, we can explain it here in a way that makes sense.
The Basics: At its core, a dividend is your share in the profits of a company you own. To understand, you have to understand the concept of shares themselves. When you buy stock in a company you aren’t just gambling on the quoted price going up. You are purchasing part ownership of a company. There are several types of stock, but for now we will deal only with the most common, appropriately known as common stock.
In return for purchasing stock, or investing in, a company you are given two basic rights. First, you have the right to participate in electing a board of directors to run the company, and second you have the right to be paid a share of the company’s profits, at the discretion of that board. This is paid in the form of a dividend. When the board of directors releases company results at the end of each quarter, they will also announce the amount of dividend (if any) to be paid per share. Thus, if a company declares a $0.50 dividend for a given quarter and you own 100 shares, you will receive $50.
Types of Dividend: There are three common types of dividend that you may hear of; cash, stock and extraordinary.
A cash dividend is what is explained above, a regular payment of your share of a company’s profits, paid in cash. Unless otherwise specified, we will deal here with cash dividends.
A stock dividend is when, rather than pay cash, the board decides to reward investors by granting them whole or partial shares in the company for each share held.
An extraordinary dividend is when a board decides to distribute cash previously held back to shareholders. This was quite common at the end of 2012, when it was forecast that capital gains tax would rise steeply in 2013. Directors at many companies felt that it was in the interests of shareholders to distribute cash before tax liabilities increased.
Payment Options: If you hold your shares in a brokerage account, you have 2 options: 1) You can be paid each dividend in cash in your account 2) You can opt for automatic dividend re-investment. In this case, any cash paid is used to purchase shares, or partial shares, in the company that paid the dividend. Option 1 is best if you own dividend paying stock to generate income, option 2 if your objective is long term growth of capital.
If you hold the shares yourself, a check will be sent to the address of record for each payment unless the company has a Dividend Reinvestment Plan, or DRIP. In that case you have the option of receiving a check or having the payment used to buy shares or partial shares in the company.
The Importance of Dividends: For those seeking income, the importance of dividends is self-evident. It is less obvious when seeking growth, but dividends are an important part of total returns over time. Indeed, since 1930, 40% of the total returns in the US stock market are attributable to dividends.
Record Date& Ex-Dividend: When a dividend is declared by a board, they also say when it will be paid. The important date for the investor is the “record date” . The dividend will be paid to the owner of the shares on that day. The next day, when the stock will be trade after (or ex) the dividend is known as the ex-date and the stock is said to be “ex-dividend”. On that day the stock will usually open lower by the amount of the dividend, all things being equal.
Advantages of Dividend Paying Stock: The most obvious advantage is that you get paid to own the stock. As explained above, these payments, usually quarterly, can be used for income or reinvested. Dividend income is currently taxed at a lower rate in the US than other forms, so there can be significant benefits for high rate tax payers. Less obviously, the ability of a company to consistently declare and pay a dividend can be a good sign for conservative investors. It means that the company is making money and expects to continue to do so.
Risks of Dividend Paying Stock: As dividends are often seen as an alternative to interest paying securities, such as bonds or CDs, the underlying price of the stock is sensitive to changes in interest rates. In a rising rate environment, stocks with good dividends can lose value dramatically.
When a company starts to pay a dividend it can mean that the board can see no other use for the cash. This means that growth through acquisition or expansion is less likely.
Calculating Yield: The yield of an asset is the percent return paid over 1 year. Thus, for dividend stocks, the yield is the sum of the last four quarterly dividends divided by the price of the stock x100. For example, let’s say you buy GE at $24.00 per share. At the time of writing the last four quarterly dividends have been $0.19, $0.19, $0.19 and $0.17, giving a total of $0.74 per share. 0.74/24.00 = 0.0308. Multiply that by 100 for a 3.08% yield.
When evaluating the suitability of stock for your portfolio, dividends are an important consideration. As with most things in life, they can be as complicated as you wish to make them, but with just a little basic knowledge, your stock selection will be much more informed.