Investing 101: How Dividends Work
A dividend is when a publicly listed company pays out a portion of earnings to shareholders. These can be paid out in cash or given as additional stock. These are given out to reward investors for entrusting their money with the company.
Who Determines the Dividend?
The Board of Directors decides two things:
If they are going to issue a dividend or invest the profits back into the company
The amount of the dividend
So, how does the Board make these decisions?
Whether or not a company issues dividends to shareholders often depends on how long the company has been around. Companies like Coca-Cola who have been around for a long time have lower growth potential and tend to pay a higher dividend because they see it as the best return for shareholders. If the Board of Directors thinks investing their earnings back into the development of the business will provide a greater return long term, they are most likely going to forego paying out a dividend or increase an existing one.
Many companies, especially newer companies, do not issue dividends. They retain earnings to help with future business activities. See the example below.
Important Dates to Note
These four dates are important to know if you qualify for a dividend and when you will receive it for owning shares of a company.
Announcement date or declaration date: This is when the Board of Directors announces its intention to pay out a dividend.
Ex-Dividend date: The ex-dividend date is the trading date on which the dividend will not be owed to a new buyer of the stock, this is one business day before the record date.
For example: If the stock has an ex-dividend date of June 26th you will only receive the dividend if you purchased the stock before the 26th of June. If you bought the stock on the ex-dividend date or after you will not receive the dividend this time around.
Record Date: This is the day on which the company checks its records to identify shareholders of the company.
Note: If you own shares of the company on its record date and sell your shares after the date you will still receive the dividend for that period. If you want the dividend you need to make sure you purchase the stock at least two business days before the record date.
Payment Date: This is the date the company issues the dividend and shareholders are paid out. Companies can pay dividends on a monthly, quarterly, or annual basis.
How Does the Dividend Affect Share Price?
When a company declares a dividend, the price tends to incorporate that dividend into the stock price. The day of the ex-dividend date is the day when the stock price is affected most by the dividend. Since new buyers of the stock will not receive the dividend the price of the stock typically drops by the dividend amount. This is because the dividend is locked into being received by the shareholders as of the previous market close, instead of the new buyers.
How to Receive your Dividend
To receive a dividend for owning shares of a company you must own the shares before the ex-dividend date. If you plan on buying the stock before the ex-dividend date, ensure you place the buy two business days before the record date so that trades have fully settled.
How are Dividends Taxed?
In the tax world there are two types of dividends: qualified and non-qualified.
Most dividends received will be qualified dividends where they will taxed at capital gain rates and receive preferential tax treatment. However, there are a few instances where dividends can be non-qualified and taxed as ordinary income. Such as the examples below.
Dividends paid out by REITs (Real Estate Investment Trusts)
Dividends paid on employee stock options
Dividends paid by tax exempt organization.
Dividends paid out by credit union, loan associations, insurance companies, mutual savings banks
Dividends are a Great Perk for Owning Stocks
Investing in companies that pay a strong dividend can be a good way to receive a return on your investment as they pay out cash on a monthly, quarterly, or annual basis. Keep an eye out for companies where the dividend isn’t sustainable based on profits. Lastly, make sure to know how your dividends are going to be taxed so you don’t have any surprises when tax time comes around.