What is a dividend?

E*TRADE from Morgan Stanley


A dividend is a payment made by a corporation to its stockholders, usually out of its profits. Dividends are typically paid regularly (e.g., quarterly) and made as a fixed amount per share of stock—the more shares you own, the larger the total dividend payment you’ll receive.

There are three main types of dividends:

  1. Ordinary dividends. This is by far the most common type of dividend. Ordinary dividends are paid in cash, most often quarterly but sometimes semi-annually or annually.
  2. Stock dividends. Companies that want to conserve their cash may pay dividends in the form of shares of stock. 
  3. Hybrid and property dividends. These are uncommon. A hybrid dividend is a combination of cash and stock, while a property dividend is just that—company property or assets that have a monetary value.

Companies may also pay what's known as a special dividend when they have an unusually profitable quarter or year. This is an extra dividend of additional cash or stock beyond the firm's current, or regular dividend.

Who receives the dividend?

When a company declares that it will pay a dividend—typically every quarter, as mentioned above—the firm also specifies a record date. The dividend is paid to anyone who is registered as an owner of the company's shares on that date. In most countries, including the US, registration is automatic and requires no special action when you buy a stock.

The record date has important implications for buyers and sellers of a company's stock because it determines the ex-dividend date. If you buy a stock on or after the ex-dividend date, you won't receive the most recently declared dividend. You're buying the stock ex, or without, the dividend. To compensate buyers for this, on the ex-dividend date the share price typically will be reduced by the amount of the dividend. In the US, as of September 2017, the ex-dividend date is one business (i.e., trading) day before the record date.

On the other side of the coin, if you’re selling a stock but want to receive the dividend, you must wait until the ex-dividend date to sell your shares. If you sell before the ex-dividend date, you’re also selling the right to receive the dividend.

To recap, these are the key dates associated with a dividend:

Owners of both common and preferred shares may receive a dividend, but the dividend for preferred shares of a stock are usually higher, often significantly so.

If you buy and sell stock through a broker, dividend payments are almost always deposited directly into your brokerage account. Otherwise, a check in the amount of the dividend payment is mailed to you on the payment date.

Why are dividends important to investors?

Investors seeking income are often drawn to companies that pay dividends. They may be more interested in the regular dividend payment than in the growth of the stock's price, or they may be looking to combine the benefits of regular income with the potential for stock price appreciation. Income from dividends also cushions the blow if a stock's price drops.

Similarly, when interest rates are low, investors may re-allocate their funds from interest-bearing assets into more productive dividend-paying stocks.

A firm's dividend policy and history might also give you important clues about the company. Paying dividends is generally considered a sign of an established company with favorable financial health and future profit potential. On the other hand, paying dividends may mean that a company has relatively modest growth prospects—it can be seen as evidence that the firm can't find a more productive use for its profits. This is why young, fast-growing companies typically do not pay dividends. They believe they can create a better return for shareholders by reinvesting all their profits in their continued growth. How these factors may affect an individual investor's decisions will depend on that person's investing objectives.

It may also be an important signal when a company that has been regularly paying dividends cuts the dividend. This could indicate financial trouble.

Of course, dividends are also a component of an investor's total return, especially for investors with a buy-and-hold strategy. With some stocks, dividends may account for a substantial percentage or even a majority of total returns over a given time period.

It may also be an important signal when a company that has been regularly paying dividends cuts the dividend. This could indicate financial trouble.

How are dividend returns measured?

Dividend yield1 is the annual return an investor receives in the form of dividend payments, expressed as a percentage of the stock's share price. It's an easy way to compare the dividend amounts paid by different stocks. It's calculated by dividing the annual dividend per share by the price per share, then converting the result to a percentage.

Dividend yield should never be the only factor an investor considers when deciding whether to buy a stock. But income-focused investors tend to prefer higher dividend yields if all else is equal. That said, high dividend yields may be a sign of a stock that's recently suffered a sharp price decline, so in some cases it may be a warning signal.

Many income-oriented investors also look for a consistent history of dividend payments, preferring companies whose dividend payments have grown over time (or at least remained steady), with no missed quarters.

What is dividend payout ratio?

A second ratio, called the dividend payout ratio, is seen by many investors as an indicator of a company's ability to continue paying dividends at its current rate. Essentially, this ratio tells you how much of a company's profits it pays out in dividends per year. It can be calculated on a total basis or per share.

A payout ratio above 100% would mean that the company is paying more in dividends than it is earning, which is unsustainable long-term.

Dividend payout ratios will vary widely based on several factors. As noted earlier, young, growth-oriented companies may have a zero, or very low payout ratio, while more established companies will often have higher payout ratios. There are also differences between industries and sectors, so this ratio is most useful when comparing companies within a specific industry.

Should dividends be reinvested?

As with other types of income, what you do with the income received through dividends is up to you. For instance, you can use it to subsidize expenses or let it accumulate in the cash balance portion of your brokerage account. Many investors prefer to use it to automatically buy additional shares or units (in the case of mutual funds and some other investments) of the security that generated it.

This option is often referred to as a Dividend Reinvestment Program or "DRIP". Originally established by publicly traded companies with direct share purchase plans, DRIPs are now generally understood to include all types of programs—including those offered by brokerage firms—that facilitate the automatic reinvestment of dividend income.

DRIPs offer several significant advantages for investors, including:

  • Convenience. DRIPS may help you automatically build out a more sizable position in a security over time. New shares are purchased on the dividend payment date, using the proceeds from the dividend.
  • Cost-effectiveness. In most cases, DRIP purchases are free from commissions and other fees, making them a low-cost option for growing your investments.
  • Flexibility. DRIP purchases can often be made in fractional share accounts. For example, if you receive a dividend of $50 from a company whose stock is currently trading at $100, the DRIP would purchase one half of a share on your behalf.
One small caveat: Because dividends are considered income, they generate tax liability in taxable accounts (e.g., traditional brokerage accounts). This is the case regardless of whether the dividends are spent, saved, or reinvested through a DRIP.

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