Dividends are one of the most powerful forces to have on your side when investing in stocks. History has shown that some of the best long term returns are realized from strong companies that pay consistent dividends and raise them regularly. Some studies have shown that stocks without dividends underperform the overall market over time. Understanding this is important but today I want to take a step back and explain what dividends are and why companies pay them.
Dividends are a form of payment to shareholders of a company. They are typically paid because a company has extra earned income that they can either use to reinvest in other growth opportunities or pay back to their shareholders. As companies mature and have less need for investment, they will often pay out dividends to their shareholders with the additional revenue that they have realized from the past quarter. An example of such a company is Coca-Cola. The company is not really inventing new products or expanding to more markets at this point. Because of this, Coke is able to pay back a portion of their revenues to shareholders in the form of a dividend.
You can figure out if a company pays a dividend by looking up the stock ticker through your brokerage account or by using many popular online stock resources that are free. Every platform that I know of will show a field that gives you three bits of information about the dividend that the company pays. If this field is blank or has a N/A, then the company does not currently pay a dividend. The first field to look for is the annual dividend, which is stated in dollars. For example, you might notice a company pays $1.00 per year in dividends. That means that you will receive $0.25 per share that you own every quarter.
The second field you’ll notice is the dividend yield. This is calculated by dividing the current stock price by the annual dividend payout. Using our example from before, the annual dividend yield would be 5% if the current stock price was $20 per share. This is simply found by calculating 1/20. Lastly, there is an ex-dividend date listed. The ex-dividend date indicates the date that you must be listed as an owner of shares in the company to receive the dividend payment. You must be an owner of shares on that date to receive the distribution. That means if you sell the stock the next day, you will still receive the dividend payment on the payout date. If you buy the stock a day after the ex-dividend however, you’ll have missed the dividend distribution for that quarter.
Dividends are not Mandatory
Quarterly dividend distributions can fluctuate or stop completely if the company gets in to trouble and starts losing money. For this reason, it’s important to monitor any stocks you own that pay dividends to make sure that your income stream stays in tact.
In addition, some companies are required to pay dividends to their shareholders. These include trusts, master limited partnerships and real estate investment trusts. Although they are required to pay dividends, their quarterly distributions can fluctuate, so if you invest in one of these companies make sure to do your due diligence.
I hope that you now have a basic understanding of how dividends work, why companies pay them and why they’re important.