What is a dividend?
A dividend is a payment of some portion of a company’s earnings to its shareholders. It usually takes the form of cash payment, but it can also be made in additional shares of stock.
The mechanism behind these payments is relatively simple. When you own stock in a company that offers one, you will be entitled to a certain amount for each of your shares. Suppose, for example, you owned 100 shares of a company that was paying out $0.50 per share. Your total payment would be $50. The more shares you own, of course, the larger your distribution will ultimately be.
The amount of each payment is set by the company before it is announced. In some cases, companies maintain the same payout for years at a time. Other companies raise or lower their distributions depending on performance and market conditions. The amount of the payout as a percentage of the company’s stock price is known as its yield.
In order to receive your distribution, though, you have to own your shares by a specific date known as the ex-dividend date. If you buy a stock on or after this date, the seller will receive the payment for the period. By holding the shares until the next time a distribution is announced, you will be entitled to the next payment.
The frequency of payments varies from company to company. Some companies pay out monthly, while others distribute lump-sum payments only once a year. The most common arrangement, however, is for the payments to be made quarterly.
Like frequency, the size of payments varies from company to company. A yield of 2-3% is fairly common and considered an average distribution. That said, some companies offer yields under 1%, while others pay as high as 8 or 9%. In rare cases, yields can break into double-digit territory. It’s important to be cautious when dealing with such high yields, though, since they are rarely sustainable and may indicate that a company is not financially healthy.
Large, established companies are more likely to pay distributions than smaller startups. Stable businesses with ample cash flow, such as oil companies, telecommunications providers, and utilities, are usually considered to be pillars of dividend investing. With that said, a surprisingly large number of stocks offer recurring payments. The vast majority of companies on the S&P 500 and about half of small-cap companies worldwide pay out regularly.
Companies that offer dividends use them as a way to reward shareholders and pass on some of their profits. Some companies, however, choose to reinvest their profits back into the business and pursue returns through higher growth instead of regular payments. In rare cases, a company that offers a distribution can stop paying out. More frequently, however, companies begin paying out dividends as they mature and have more free cash flow to return to shareholders.
Stocks that regularly distribute payouts can be quite useful in your portfolio for a number of reasons. First and foremost, they allow you to generate income from your investments without having to sell your shares. With dividend-paying stocks, your stock equity can continue to grow while you draw off a fairly predictable stream of income.
Regular payments from profits can also be a sign of a stable, safe company that’s generating a good profit. While this isn’t always the case, being able to offer a sustainable distribution is usually an indication that a company is doing well.
Finally, these stocks can be good hedges against inflation. During periods of high inflation, reinvesting your payments can help your portfolio stay ahead of a weakening dollar. In retirement, dividends are also a helpful addition to other forms of income that can help to ease the loss of purchasing power when inflation strikes.
Dividend case study
Your earnings will vary based on what your stocks pay. If you had $100,000 invested in a stock yielding 3%, for example, you would earn $3,000 annually. While some stocks do offer much higher yields, excessively large distributions are often unsustainable and risky.
The bottom line
Dividends are payments distributed to shareholders based on the value of a stock. These payments are made at specific intervals, and their volume is determined by the company. When you own shares in companies that make these payments, it can help you generate income from your investments and ride out periods of high inflation.
