What are Dividends and How Do They Work?

Dividends are a way for companies to distribute part of their earnings to shareholders on an ongoing basis. An amount per share, also known as a percentage of the share price is allocated to the dividend and then it’s distributed on a regular basis. In most cases that’s on a quarterly basis. Some companies distribute their dividend monthly.

A Company passes their profits along to shareholders in two ways. The first is for the company to make a dividend payment to it’s shareholders. The second is to reinvest their profits in the company. If done correctly this can allow the company to become more valuable over time while providing a tax savings to shareholders (dividends can be taxed in non retirement accounts).

Ever wonder why people invest in dividend stocks? While a dividend cannot be relied upon as a guaranteed payment, some people do invest in dividend stocks and use them to replace all or part of their income. Retirees and those that choose the Financial Independence, Retire Early (FIRE) method are two types of individuals that use dividend payments to supplement their income. Those that invest in dividends must keep in mind that the current dividend and all future dividend payments can be cut or eliminated altogether if the companies board of directors chooses to do so.

One of the first things to look at while evaluating a company that pays dividends is the payout ratio. The payout ratio is the percentage of net income that the company pays out to shareholders in the form of dividends. A company that pays out too much of it’s profits in the form of a dividend cannot expect to sustain it’s growth and it’s dividend. If your interested in investing in dividend stocks our post How to Invest in Dividend Stocks using Value Investing Principals will take you through the steps of evaluating dividend stocks.

Companies pay dividends on the pay date. In order to receive a dividend you’ll need to buy shares in the company before the ex dividend date. There are four dates you’ll want to know about regarding dividend payments:

Declaration date: The date on which the board of directors of the company establish and communicate the next dividend payment.

Ex dividend date: If you’ve purchased shares of a company on or after this date you will not receive the upcoming dividend, however if you hold the shares through the next ex dividend date then you’ll receive the next dividend.

Record date: The date on which the company documents the shareholders that are eligible to receive the dividend.

Pay date: The pay date is the date which the shareholders of record receive the dividend. This date usually occurs several weeks after the record date.

Special dividends and Preferred dividends differ from ordinary dividends paid on common stock mentioned previously. A special dividend is a non reoccurring dividend payment that can be paid as a result of strong company earnings, or a structural change within a company. Preferred dividends are dividends that are paid on preferred shares of company stock called preferred stock.

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