What do you look for in companies you wish to invest in? There's a lot to consider - what's a safe investment, what's a good pick for a diverse portfolio, etc. One thing investors may look for is more of a tangible reward for their sound investment.
The potential for "rewards" can be found in investments that pay dividends. Dividends not only let you share in the success of a company, but can even help you gauge just how well the company's finances are - or whether they're on the decline. Many companies, even billion dollar ones like PepsiCo (PEP) - Get Report and General Motors (GM) - Get Report , pay dividends to those who invest in their stock.
Not every company pays the same amount in dividends, nor do they always do it at the same rate. There's a lot more to dividends than just seeing if a company offers them when you invest. But first: what exactly is a dividend?
What Is a Dividend?
Dividends are a form of payment given by a company to its shareholders, very often a lump sum. This dividend is your share of the profits the company makes, and essentially operates as proof the company is making a profit.
Not every company starts giving out dividends once it's turning a profit. They may choose to table dividends for the time being and instead reinvest the money into the company. If their plan for the reinvested money succeeds and the company maintains its profitability, it may then announce a plan for dividends.
Because dividends can only really be paid if the company is profiting, and in some cases not given out until well into a company's stretch of profitability, they are often given out as a show of financial strength on the company's part. Showing that the company has the ability to pay out dividends to the shareholders can catch other savvy investors' eyes, and should more of them choose to invest, the price of those shares may increase quite a bit.
Dividends aren't always large payments, but even those can be used as supplemental income, or even to reinvest into your portfolio if you want. Some dividend payments are large, though. And shareholders with enough shares in a thriving company with large dividends get enough that some even use it as their main source of income. This is obviously not what a new investor should expect when making their first investment in a company that pays dividends, but the right investment can lead to a lot of money.
These investors can reliably use dividend payments as income because even though the rate at which they're paid out varies from company to company, they are still always announced in advance. The company's board of directors helps decide if the company will be paying out dividends. Once they do, it is time for the dividend declaration date. That's when the board makes a declaration (generally via a press release) that a dividend will be paid, how much the payment will be and the date of payment.
After the declaration date is the record date, when the company checks its records for shareholders who currently own stock. Shareholders and prospective shareholders alike need to know not just the record date, but what follows it: the ex-dividend date.
The ex-dividend date is usually a few days before the record date. If you own stock before the ex-dividend date, you will show up on the record date and be eligible for the dividend payment. If you buy the stock on or after the ex-dividend date, you are not eligible for the upcoming dividend payment. The seller of the stock will instead receive the payment. Finally, there's the payable date which, as you likely gathered, is the day the dividends are actually paid out.
Types of Dividends
Though there are a few other types of dividends used far less, the two most common forms of dividends given out to shareholders are cash and stock dividends.
Of those two, cash is easily the more common form. Simply put, it's your share of the profits in cold hard cash. These dividends are generally paid out per share, rewarding those with a higher volume. A dividend payment of $5 a share may not sound like a lot if you only have a few shares, but if you have 200 shares on the record date you're making $1,000 in dividends.
Dividends are often (though not always) paid out quarterly. It's easy to see how a wealthy investor with hundreds or thousands of shares in a company that pays cash dividends can make a lot of income.
Cash dividends, since they affect the company's market cap, also affect the share price. If this company with $5 dividend payments is valued at $100 per share, the dividend would cause the shares to slide down to $95.
Stock dividends are when, in lieu of cash, companies instead give out shares. This may be done by companies who wish to give out dividends and reward shareholders, but don't necessarily have the cash to give to them (or simply don't want to). These are new shares, although their existence can impact your existing shares.
These stock dividends are announced as a percentage. A 5% stock dividend, for someone with 200 shares, means you would receive 10 new shares (200 x 0.05).
The company is issuing new stock for these dividends, so share prices tend to get reduced to account for the new shares that now exist. As an example, let's say the company with $100 shares is valued overall at $100 million. Prior to the dividend, there were 1 million shares. $100 million divided by 1 million equals $100. With a 5% stock dividend, though, 50,000 new shares have been added. Now it's $100 million divided by 1,050,000, leading to a new share price of about $95.24.
A type of dividend used far less often includes property dividends, in which the company gives shareholders assets in lieu of cash or stock.
What Are Dividend Yields?
The dividend yield is the ratio of stock dividend to share price, a figure often used to determine the return the shareholder is making specifically on their dividend.
Be careful if you see a company you're interested in with a high dividend yield, though. Those who choose to get involved in dividend investing often do so because of the potential for passive income; do nothing but invest, and a few times a year you get money as a result. Sounds like a solid deal in theory. In the short term, a high dividend yield could get you a lot of money quickly.
The problem, though, is that to consistently make a good living through dividend investing you have to do it for years. Not just that, but you have to get very lucky even compared to the usual amount of luck required in the stock market. Companies that pay high dividends, while tempting, are extraordinarily risky. There's a lot to be researched about a company before deciding to get in on future dividends.
Earnings reports and balance sheets are crucial. If a company is giving out particularly high dividends, how does it compare to the overall market value of the company? How are they doing on income and can it be reasonably assumed that their method of making income is stable for the foreseeable future? Look into past dividend payouts as well. Have they been growing over time, and is there reason to believe that growth will continue?
Growth in dividend yields and shares with dividends isn't the most common occurrence, however. Dividends are literally the profit the company makes being given to the shareholders. Without investing the money back into the company or its workforce, there is far less potential for growth.
All this to say, high dividend yields aren't the guaranteed moneymaker or sound investment you may think. Research as much as you can about the company's finances and how they factor into the yield before making your investment.
How to Calculate Yields
Calculating dividend yield is fairly simple. The equation for calculating it is:
Annual Dividend / Current Stock Price = Dividend Yield
Let's use an example. You've invested in a company whose shares sell for $125, and the annual dividend comes out to $5. $5/$125 = 0.04, or a dividend yield of 4%.
The dividend yield has an inverse relationship with the stock price. If the price goes up, the yield goes down, and if it decreases, the dividend yield increases. Let's say the annual dividend is still $5, but the stock has increased to $140. $5/$140 = 0.036, or a yield of 3.6%. Shares are up, but you're getting less of a return on the dividends as a result.