Oct 2, 2022
How Do Dividends Work? The Beginner Investor’s Guide
What is a dividend stock?
A dividend is a portion of a company’s profits paid out to its investors.
Dividends are one of the many ways investors can earn a return on their stock investments. Compared to other investment avenues, investing in stocks that pay dividends is a preferred strategy for several reasons: they’re less volatile than growth stocks, can reduce portfolio risk, and generate a consistent cash flow. And when you reinvest dividends, you can take advantage of the power of compounding to build more wealth over time.
When you buy a dividend stock in a publicly traded company, a portion of the company’s profits, or a dividend, is distributed to shareholders on a regular basis, usually quarterly.
In short, dividends are a way to get a share of a company’s growth when they earn revenue.
Dive into our beginner-friendly guide for answers to questions like:
- How do stock dividends work?
- How are dividends paid?
- Do all stocks pay dividends?
We’ll start by breaking down how dividends work in the next section.
Not all companies pay dividends. But those that do pay them per share of stock, or the number of shares an investor owns in a company.
For instance, if you own 50 shares in a company that pays $1 in dividends annually, you’ll earn $50 per year. Dividends are considered taxable income and may be subject to taxes.
To understand how stock dividends work, start by learning the different types of dividends a company may use to pay shareholders:
- Regular dividends: This is the most common type of dividend. Companies usually pay a flat amount per share of stock you own, regardless of the company’s financial performance. Generally, dividend payments are issued on a predictable cadence, like once every quarter.
- Dividend reinvestment programs (DRIPs): These are dividends paid in the form of additional shares of stock instead of cash, which investors can reinvest back into the company, often at a discount.
- Variable dividends: Unlike regular dividends, the amount of these payments is determined based on a company’s earnings over a certain time period. They’re often paid on a consistent cadence, but not always.
- Special dividends: Sometimes, a company will issue a one-time payment in the form of a special dividend. This may be because they’ve been especially profitable or have a surplus of cash without an immediate need, and they want to share the wealth with investors.
How often are dividends paid? Key dates to know
When you own a dividend stock, the company will issue payments based on the type of dividend they offer, usually quarterly. The company’s board of directors must approve each dividend before the payment process can begin. Understanding the dividend payout process comes down to knowing a few key dates:
- Declaration date: The date the dividend is declared
- Ex-dividend date: The date by which investors must own the stock to be entitled to receive dividends
- Record date: The cut-off date that determines which shareholders are eligible to receive dividends
- Payment date: The date when investors will receive payment, typically one month after the record date
Once dividends have been approved, qualified shareholders are usually notified by press release. While most U.S. companies pay dividends quarterly, some pay them monthly or semiannually. Non-U.S. companies usually pay dividends once or twice a year. Mutual funds and exchange-traded funds (ETFs) typically pay out dividends quarterly or annually.
Want to check how often your stock pick pays dividends? Your brokerage likely publishes a dividend calendar, as do most stock markets, like the New York Stock Exchange and Nasdaq. You can also get information about upcoming dividends in stock charts.
How to identify companies with strong dividend stocks
If you want to invest in stocks that pay dividends, you’ll need to research which companies offer them. Generally, established companies (think ExxonMobil or Walmart) are more likely to pay dividends. These businesses, while often solidly profitable, don’t see the same aggressive growth as tech companies, for example—so their stock doesn’t gain value as rapidly. They may need to ice the cake with dividends to attract investors.
On the other hand, new or rapidly growing companies are less likely to pay dividends. Startups and fast-growing businesses tend to prioritize investing their profits into growing the business instead of paying dividends. They might also be counting on the potential for their share prices to rise as a way to entice investors in the future.
In general, investors after stocks that pay dividends should look for companies with a record of dividends that increase each year (which are most likely to come from well-established companies).
Investor tip: If you’re not ready for the research required to pick individual stocks, you can still invest in dividend-paying stocks through mutual funds or ETFs.
How to find the healthiest dividends—and invest in them
Once you’ve narrowed down some potential dividend-paying companies, you’ll want to evaluate each of their dividends to decide on the best one. The following methods explain how.
Dividend yield is a common starting point for evaluating a company’s dividends. This is a stock’s annual dividend payments expressed as a percentage of the stock’s current price. It’s found by dividing the annual dividend per share by the stock price.
For example, a $100 stock that pays an annual dividend of $5 per share has a 5% yield.
Generally, 4% is a good sweet spot for favorable dividend yields. Keep in mind that dividend yield isn’t set in stone—it can change due to market fluctuations or if the issuing company increases or decreases their dividends. It’s best used as a helpful tool for quickly comparing stock dividends, and shouldn’t form the sole basis of your stock decisions.
Dividend payout ratio
The dividend payout ratio is another quick way to measure a dividend’s safety. This figure represents how much a company pays to investors relative to its total earnings. It’s found by dividing a company’s total dividend share by its earnings per share (EPS) for a set time period.
If a business with a net income of $100 million pays $35 million in dividends, its payout ratio would be 35%. Some experts say that a 35% to 55% payout ratio is a sign of stability. Within this range, a company can maintain dividend payments and still reinvest in the business with room to grow the dividend down the line.
Investor tip: Be wary of high payout ratios—this could indicate that a company isn’t holding back enough cash to handle an emergency or new opportunities. The higher the payout ratio, the higher the risk of dividend cuts if the business takes a turn for the worse.
Like dividend yield, the dividend payout ratio is just one indicator of a company’s health. It’s a good idea to research stocks more broadly before investing.
Dividend stocks can be an important part of a well-balanced portfolio, and reinvesting your payouts may help build your portfolio further. New investors might consider starting with dividend-focused mutual funds and ETFs before picking individual stocks. As you try out different approaches, you may find your confidence growing, along with your portfolio.
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FAQs about how dividends work
Have more questions about how dividends work? We have answers.
Why do people invest in dividend stocks?
Many investors invest in dividend stocks because they can provide a stable source of income even during an unstable market. Besides being generally less volatile than non-dividend-paying stocks, they can also be reinvested to take advantage of the power of compounding and build wealth over time.
Why do some companies pay dividends and others don’t?
Since dividend-paying companies are generally perceived as financially stable, most companies pay dividends to attract investors. But some companies prefer to remain growth-oriented, choosing to reinvest profits back into the business instead of distributing them to shareholders.
How are dividend stocks taxed?
Qualified dividends are taxed at a significantly lower rate than regular income. Per the IRS, for individuals earning less than $80,000 per year, dividends are tax-free. For individuals earning between $80,000 and $441,450, dividends receive a 15% tax rate.
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