Many new investors are unfamiliar with the concept of dividends as they apply to investments, particularly individual stocks or mutual funds. A dividend is a payment made by a publicly traded company to eligible stockholders of a portion of its profit.
However, not all businesses pay dividends. Typically, the board of directors decides whether a dividend is desirable for their company based on a variety of financial and economic factors. Dividends are typically paid to shareholders in the form of cash distributions on a monthly, quarterly, or yearly basis.
Key Points
- Dividends are a profit distribution made at the discretion of a company’s board of directors to its current shareholders.
- A dividend is a cash payment made to investors at least once a year, but sometimes quarterly.
- Dividend-paying stocks and mutual funds are likely to be financially sound, but not always.
- Extremely high yields should be avoided by investors because there is an inverse relationship between stock price and dividend yield, and the distribution may not be sustainable.
- Dividend-paying stocks typically provide portfolio stability but do not outperform high-quality growth stocks.
Dividend Basics
Before receiving a dividend payout, or distribution, shareholders of any given stock must meet certain requirements. To be eligible for the dividend, you must be a “shareholder of record” on or after a specific date set by the company’s board of directors. Stocks are sometimes referred to as trading “ex-dividend,” which simply means that they are trading without dividend eligibility on that particular day. You will not receive the most recent dividend payout if you buy and sell stock on its ex-dividend date.
Now that you have a basic understanding of what a dividend is and how it is distributed, let’s go over what else you should know before making an investment decision.
What Does Dividend Yield Mean?
It may seem counterintuitive, but as a stock’s price rises, so does its dividend yield. Dividend yield is a measure of how much cash flow you get for every dollar you invest in a stock.
Many inexperienced investors may mistakenly believe that a higher stock price equates to a higher dividend yield. Let’s look at how dividend yield is calculated to better understand this inverse relationship.
Dividends are typically paid out per share. If you own 100 shares of ABC Corporation, your basis for dividend distribution is 100 shares. Assume for the moment that ABC Corporation was purchased at $100 per share, implying a $10,000 total investment. Profits at ABC Corporation were unusually high, so the board of directors agreed to pay a cash dividend of $10 per share to shareholders each year. As a result, if you continue to own ABC Corporation for a year, you will receive $1,000 in dividends. The annual yield is calculated by dividing the total dividend amount ($1,000) by the stock’s cost ($10,000), which equals 10%.
If ABC Corporation was purchased at $200 per share instead, the yield would be 5% because 100 shares would now cost $20,000 (or your original $10,000 would only get you 50 shares instead of 100). As shown above, if the stock price rises, the dividend yield falls, and vice versa.
Dividend-Paying Stock Evaluation
The real question is whether dividend-paying stocks are a good long-term investment. Dividends are derived from a company’s profits, so it is reasonable to assume that dividends are generally a sign of financial health in most cases. Purchasing established companies with a history of paying out good dividends adds stability to a portfolio. If you hold your $10,000 investment in ABC Corporation for one year, it will be worth $11,000, assuming the stock price remains unchanged. Furthermore, if ABC Corporation trades at $90 per share a year after you bought it for $100, your total investment after dividends is still break even ($9,000 stock value + $1,000 in dividends).
This is the allure of dividend-paying stocks: they help cushion declines in stock prices while also providing an opportunity for stock price appreciation and a steady stream of dividend income. This is why many investing legends, such as John Bogle and Benjamin Graham, advocate buying dividend-paying stocks as a critical component of an asset’s total “investment” return.
The Dividend Risks
Almost all of the major banks reduced or eliminated dividend payments during the 2008-2009 financial crisis. For hundreds of years, these companies were known for paying out consistent, stable dividends each quarter. Despite their illustrious histories, many dividends were reduced.
Dividends, in other words, are not guaranteed and are subject to both macroeconomic and company-specific risks. Another disadvantage of investing in dividend-paying stocks is that dividend-paying companies are not typically high-growth leaders. There are some exceptions, but high-growth companies rarely pay significant dividends to shareholders, even if they have outperformed the vast majority of stocks over time. Growth companies typically spend more money on R&D, capital expansion, retaining talented employees, and/or mergers and acquisitions. For these companies, all earnings are considered retained earnings and are reinvested back into the company rather than distributed to shareholders as a dividend.
It is also critical to avoid companies with extremely high yields. As we’ve seen, if a company’s stock price continues to fall, its yield rises. Many inexperienced investors are enticed to buy a stock solely on the basis of a potentially lucrative dividend. There is no hard and fast rule for determining how much is too much in terms of dividend payout.