Stock Investing 101 – Cash Dividend

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By Prajakta Dhopade on July 17, 2020

Investing 101: Dividends explained

By Prajakta Dhopade on July 17, 2020

These tiny payments can really transform your portfolio

M A K I N G B A N K

Do you know what a dividend is? If you’re not already pretty entrenched in investing you may not have a clue—And that’s okay. These things weren’t part of the curriculum, were they? (Now, the Pythagorean theorem, on the other hand, is forever engraved into my brain and let me tell you, it’s not going to make me any money.)

So, let’s get into it.

What are dividends, and why should you care about them? Dividend stocks are stocks that you buy that pay you for being invested in them. Well, it’s not the stock that pays you, it’s the company whose stocks you’ve bought that’s giving you a little gift for being a shareholder.

That money—the dividend—is technically part of the company’s profit that’s being given back to the shareholders. Sometimes these payments are worth mere pennies per share. That may sound insignificant, but they can really add up.

Consider this. Let’s say you own 1,000 shares trading at $10 per share. Now let’s assume that company pays a quarterly 1% dividend. On a per share basis, you’d get 10-cents, but on 1,000 shares your dividend would be worth $100 on those shares. Not bad deal for simply owning a stock.

That percentage figure is commonly referred to the dividend yield, which is simply a ratio that compares how much a company will pay out in dividends in a year, compared to that company’s share price. As you start to look around you’ll discover some stocks have high yields (say 5% or more) while others might be smaller. Before I go on, a word of caution: while high dividend yields are enticing they can also be a sign of a company in trouble—but more on that in a moment.

First, lets consider a real-life example. TD Bank, for instance, has a share price of $65.83 and a dividend yield of 3.68%, meaning over the course of the year you can expect to get $2.42 per share back in dividends. It might not sound impressive, but trust me it is. Since dividends are often paid out every quarter, you’d get 60.5-cents per share, per quarter. If you’d owned 100 TD shares then you’d get back $60.56 in dividends. At the end of the year you’d have collected about $242 in dividends.

Remember, since the yield is based on the share price it will fluctuate over the course of a year, but barring some calamity, the amount you’ll collect in dividends should remain constant. Confused? Look at it this way. Let’s say TD’s shares shoots up to $100 per share. The dividend yield now would be 2.42%, and as you can probably guess the annual dividend would still be $2.42 per share.

Your entire portfolio shouldn’t be full of stocks, but it’s not a bad idea to make sure the ones you do own have good dividends so you’re making even more money. What’s more, those dividends can be reinvested, giving you new shares in the company, which allows you to collect even more dividends.

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But before you go out on an investing adventure and buy every stock with a high dividend yield, watch out.

A high dividend yield isn’t always a good thing. That’s important to remember. You really don’t want to get fooled by a 10% dividend yield. Don’t let double-digit numbers deceive you. A high yield percentage could just mean that the value of the stock has fallen, and that the company is going to soon cut the dividend. Now that you know the basics, here’s what you need to know about buying a quality dividend stock:

Be sure to check back for regular updates as Prajakta leads us on a journey as she learns what it takes to invest her own money.

The Beginner’s Step-By-Step Overview of How Dividends Work

Many people have wondered what it would be like to sit at home, reading by the pool, living off of the passive income that arrives in the form of dividend checks delivered regularly through the mail. This common dream can become a reality, but you must understand what dividends are, how companies pay dividends and the different types of dividends that are available such as cash dividends, property dividends, stock dividends, and liquidating dividends before you start altering your investment strategy.

This step-by-step Dividends 101 resource will walk you through the basics, ensuring that you have a solid foundation before diving into the more practical content in the Ultimate Guide to Dividends and Dividend Investing.

By starting here, you’ll learn to avoid tax traps such as buying dividend stocks between the ex-dividend date and the distribution date, which effectively forces you to pay other investors’ income taxes. You’ll also learn why some companies refuse to pay dividends while others pay substantially more, how to calculate dividend yield, and how to use dividend-payout ratios to estimate the maximum sustainable growth rate for a given company’s dividend.

How a Company Pays Dividends and the Three Dividend Dates that Matter to You

Companies that earn a profit can either pay that profit out to shareholders, reinvest it in the business through expansion, debt reduction or share repurchases, or both. When part of the profit is paid out to shareholders, the payment is known as a dividend. For many investors, “living off dividends” is the ultimate goal. (For more information about this, you can read the 10 Steps to Successful Income Investing for Beginners).

The Dividend Process

Dividends must be declared (i.e., approved) by a company’s Board of Directors each time they are paid. There are three important dates to remember regarding dividends:

  • Declaration date: The declaration date is the day the Board of Directors announces its intention to pay a dividend.
  • Date of record: This date is also known as the “ex-dividend” date. It is the day upon which the stockholders of record are entitled to the upcoming dividend payment.
  • Payment date: This is the date the dividend will actually be given to the shareholders of the company.

A vast majority of dividends are paid four times a year on a quarterly basis. This means that when an investor sees that, for example, Coca-Cola pays an $0.88-per-share dividend, he will actually receive $0.22 per share four times a year. Some companies pay dividends on an annual basis.

Cash Dividends, Property Dividends, and Special One-Time Dividends

Cash Dividends

Regular cash dividends are those paid out of a company’s profits to the owners of the business (i.e., the shareholders). A company that has preferred stock issued must make the dividend payment on those shares before a single penny can be paid out to the common stockholders. The preferred stock dividend is usually set whereas the common stock dividend is determined at the sole discretion of the Board of Directors. For reasons discussed later, most companies are hesitant to increase or decrease the dividend on their common stock. (You can find a detailed discussion of preferred stock and its dividend provisions in The Basics of Investing in Preferred Stock.)

Property Dividends

A property dividend is when a company distributes property to shareholders instead of cash or stock. Property dividends can literally take the form of railroad cars, cocoa beans, pencils, gold, silver, salad dressing or any other item with tangible value. Property dividends are recorded at market value on the declaration date.

Special One-Time Dividends

In addition to regular dividends, there are times a company may pay a special one-time dividend. These are rare and can occur for a variety of reasons such as a major litigation win, the sale of a business, or liquidation of an investment. They can take the form of cash, stock, or property dividends.

Stock Dividends Are Not Stock Splits

Stock Dividends

A dividend paid in stock shares rather than cash is a pro-rata distribution of additional shares of a company’s stock to owners of the common stock. A company may opt for stock dividends for a number of reasons including inadequate cash on hand or a desire to lower the price of the stock on a per-share basis to prompt more trading and increase liquidity (i.e., how fast an investor can turn his holdings into cash).

Why does lowering the price of the stock increase liquidity? On the whole, people are more likely to buy and sell a $50 stock than a $5,000 stock; this usually results in a large number of shares trading hands each day.

A Practical Example of Stock Dividends:

Company ABC has 1 million shares of common stock. The company has five investors who each own 200,000 shares. The stock currently trades at $100 per share, giving the business a market capitalization of $100 million.

Management decides to issue a 20% stock dividend. It prints up an additional 200,000 shares of common stock (20% of 1 million) and sends these to the shareholders based on their current ownership. All of the investors own 200,000, or 1/5 of the company, so they each receive 40,000 of the new shares (1/5 of the 200,000 new shares issued).

Now, the company has 1.2 million shares outstanding; each investor owns 240,000 shares of common stock. The 20% dilution in the value of each share, however, results in the stock price falling to $83.33. Here’s the important part: the company (and our investors) are still in the exact same position. Instead of owning 200,000 shares at $100, they now own 240,000 shares at $83.33. The company’s market capitalization is still $100 million.

A stock split is, in essence, a very large stock dividend. In cases of stock splits, a company may double, triple or quadruple the number of shares outstanding. The value of each share is merely lowered; economic reality does not change at all. It is, therefore, completely irrational for investors to get excited over stock splits.

Dividend Investing 101

If you’re new to dividend investing, Dividend Investing 101 is the place to start. This section highlights the theory and key concepts behind dividend investing, including the basics on dividends, dividend reinvestment plans (DRIPs), dividend yield, and dividend dates.

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