Stock Dividends: What They Are and How They Work
When companies turn a profit, they have several choices with respect to next steps. While one option is to reinvest the money to help grow the business, another is to buy back some of their outstanding shares (often to raise their share price and create value for shareholders). A third option—detailed in this post—is to share profits with shareholders in the form of dividends.
While investing in stocks that pay dividends is perhaps appealing to an investor such as yourself, you should also keep in mind the associated risks and potential tax implications discussed herein.
What is a stock dividend?
A dividend—a payment a company makes to its shareholders akin to a “bonus” or “reward” received for owning the stock—is paid out per share. For example, if a company pays out $0.50 per share of stock and you own 100 shares, you’ll receive $50. Generally speaking, dividends are paid regularly (often quarterly), but not all stocks pay them and companies can reduce or even eliminate them at any time.
Types of stock dividends and how they work
A company can pay its shareholders several types of dividends. The most common? Cash dividends (as per the previous example) wherein shareholders have the option to reinvest them in additional company stock via a dividend reinvestment plan (DRIP). Just as the name implies, these programs automatically reinvest dividends in fractional shares of company stock that can accumulate over time.
Companies can also pay investors stock instead of cash, known as a “scrip dividend.” In this scenario, you’re paid based on the number of shares you own (e.g., if a company offers a 5% scrip dividend and you own 1,000 shares, you’ll receive an additional 50).
Another type of dividend, often referred to as a “special dividend,” is a one-time payment most commonly triggered when a company declares exceptionally strong earnings. Finally, “preferred dividends” are paid to owners of preferred stock (more on that later).
How to identify stocks that pay dividends
Dividends are often paid out by well-established companies with a history of growth and earnings (e.g., 3M Company or Proctor & Gamble) as a great way to share profits with investors—and an excellent tool for attracting new ones! Conversely, new or start-up companies often reinvest profits rather than pay out dividends given their focus on growth.
When you search for a company’s stock, related data will often include the dividend per share and dividend yield (measuring the value of the dividend compared to the stock price).
Types of investments that pay dividends
Common stock
Those who own at least one share of common stock are officially company shareholders and therefore enjoy corporate policy voting rights and the ability to elect the organization’s board of directors.
A share of common stock, over the long term, also generally outperforms other types of ownership equity and can thus create significant returns for investors—making this an attractive investment! Common stock is also sometimes the riskiest option, however; in the event of bankruptcy, shareholders have a right to company assets only after bondholders, preferred stockholders, and other debtholders are paid in full.
Preferred stock
Preferred stocks—more of a hybrid investment type given similar properties to both common stock and bonds—are purchased in the same way and pay out dividends just like common stock but differ in that dividends are agreed upon and paid at regular intervals. Their market value is also sensitive to interest rate changes.
A few advantages of preferred stocks are that they pay a higher dividend rate than common stock issued by the same company, and the issuing company must pay out preferred stock dividends before common share dividends. Preferred stockholders also rank higher than common stockholders in the event of liquidation, with preferred stocks generally considered less risky than common stocks due to these collective benefits.
Unlike common stock shareholders, however, their preferred stock counterparts typically don’t have voting rights.
Mutual funds
Mutual funds—often comprised of stocks, bonds, and short-term assets (e.g., money market funds) or a combination of the three—pool money from investors to purchase securities. Investors buy fund shares or units, which are then invested and managed by a professional portfolio manager.
Fund assets are referred to as “holdings” and vary based on fund objectives. For example, a small-cap fund comprised only of smaller company stocks is riskier than a large-cap mutual fund with holdings made up of large company stocks.
Mutual funds are popular among many investors as they offer an easy way to diversify and distribute risk across several investments.
Benefits of dividend-paying stocks
There are several reasons to invest in dividend stocks. For starters, they can help protect against market risk by offering a near-guaranteed partial return on investment—very rarely will dividend-paying companies stop paying them—whereas stocks don’t always increase in value. Dividend stocks can also thereby help reduce overall portfolio risk by potentially mitigating any stock price declines.
Dividends also offer tax advantages depending on the stock and how long it’s held. For example, qualified dividends are taxed at long-term capital gains rates that are lower than ordinary rates. Nonqualified dividends (i.e., “ordinary dividends”), meanwhile, are taxed at one’s regular income rate. To be considered “qualified,” the dividend must be paid by an American company or foreign business that trades in or has a tax treaty with the U.S. Investors must have also owned the stock for at least 60 days prior to the ex-dividend date (the “ex-date”), the deadline to buy a stock and receive the dividend.
Dividend stocks can also help shield you from inflation. Should your investment increase 2% over the year amidst 3% inflation, for example, dividends can help minimize (or even completely protect you from) this 1% loss. Many dividend-paying companies also offer dividend yields (calculated by dividing the dividend paid by the stock price) that outpace inflation.
Risks of dividend-paying stocks
When it comes to dividend-paying stocks, the biggest risk is related to interest rates—specifically the potential for losses due to fluctuations in the same. High-dividend stocks are generally more popular when interest rates fall and less attractive when the Federal Reserve hikes them up. Why? Because when interest rates increase, so too do borrowing costs; higher rates can therefore diminish a company’s capacity to maintain or raise dividend payments. As a result, investors often prefer bonds (e.g., Treasury bonds) as these types of investments offer predetermined interest payments at regular intervals.
The bottom line on stock dividends
While investing in stocks that pay dividends is sometimes beneficial, the decision to incorporate them into your portfolio ultimately depends on your overall investment strategy.
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FAQs
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Several factors influence whether a stock is worth considering, and a high-dividend yield doesn’t necessarily mean a company has robust financials. That said, an annual yield between 2% (historical approximation for the S&P 500) and 5 or 6% (U.S. Treasury yield) is generally considered good.
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A high-dividend yield can sometimes signal potential problems, especially if the company is experiencing difficulties; organizations sometimes offer these to attract investors and maintain a favorable image despite questionable financial health. To illustrate, let’s assume a stock trades at $75 and pays $2 per share quarterly (or $8 a year). In this scenario, the dividend yield is 10.7%. If the company reports a significant decline in earnings and the stock drops to $50, however, the dividend yield will rise to 16%.
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Disclosures:
This document is a summary only and is not intended to provide specific advice or recommendations for any individual or business.
Preferred stock dividends are paid at the discretion of the issuing company. Preferred stocks are subject to interest rate and credit risk. As interest rates rise, the price of the preferred falls (and vice versa). They may be subject to a call feature with changing interest rates or credit ratings.
All investing involves risk, including loss of principal. No strategy assures success or protects against loss. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.
