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A dividend is a distribution of earnings paid to the company’s shareholders. It is a magnificent benefit of owning shares of companies with strong profits. A company will make excess cash, and stuff that cash into shareholders’ pockets every quarter. They are a wonderful way to reward folks for their investment in a company.
What is a Dividend?
Dividends are paid by the company to the shareholders of the company. These payments are how companies distribute their profits back to the shareholders and how investors create income.
In the US, firms usually pay dividends on a quarterly basis. You may receive monthly payments or bi-annually as well. Dividends are paid on a per-share basis. For example, if you own 30 shares in a company, and the firm pays $4 per share, you will receive $120 for the year.
However, not every stock investment will pay dividends. You have to choose the right dividend stocks to get your share of profits.
How Do Dividends Work?
Dividend shares are paid by companies through cash directly into the brokerage account of the shareholder. Some companies may also pay in the form of new shares of stocks. Many firms will offer DRIPs, dividend reinvestment programs, which allow investors to reinvest the payment back into the stocks of the company. Often, this purchase comes at a discount.
The board of directors needs to approve each dividend. After this, the company announces when the dividend will be paid, the amount, and the date of the ex-dividend. Investors need to own shares in the company by the ex-dividend date to receive their payments. To investors, this date is really important because of the following reasons:
- You must own the stock before this date
- Any stock purchased after this date is not eligible for a dividend.
- If stocks are sold after this date, you are still entitled to the dividend.
If you don’t want to research and invest in individual stocks, then you can pick exchange-traded or dividend mutual funds. These funds are designed to hold different dividend stocks from different companies but only require one investment. The funds are responsible for distributing the dividend to investors.
What is a Dividend Yield?
Online brokers or financial platforms have reports that outline the dividend yield of companies. It is shown as a percentage. are measures of the annual dividend of the company based on the stock price according to a specific date. The yield of the dividend ensures that the playing field is even, and individuals can make an accurate comparison of the stocks.
For example, a $10 stock pays $0.40 annually. It will have the same yield as a $100 purchase paying $4 annually. In both cases, the yield is the same 4%. Yields are inversely related, which means when one goes down, the other will go up.
For the dividend yield to go up, there are two things that need to happen.
- First, the company could increase the rate of the dividend. This means that on a $100 stock with a yield of $4, the company could increase the dividend by 10%. This can result in a $0.40 increase per share. If the price of the stock doesn’t change, the total yield goes up to 4.4%.
- Secondly, the price of the stock could go down. If the dividend remains the same, the $100 stock with $4 will decrease to $90 per share. This would also increase the dividend yield to 4.4%, but the amount would be the same $4.
If you find that the yield for the dividend stock is more than 4%, you should analyze it carefully. It could indicate that the payout from the dividend isn’t sustainable. There are some exceptions to this rule, though. Some stock sectors are designed to pay out dividends, such as real estate investment trust funds. Such funds can have a yield of 5-6% with plenty of growth potential.
The Dividend Payout Ratio
One of the fastest ways to measure the safety of a dividend stock is to look at the payout ratio. This is the ratio of the net income that goes into the dividend payments. If the company is paying back 100% or more of the income towards the dividend, it could mean trouble.
In tough times, profits can slow down, making it hard for the company to cover the cost of the dividend payments. Generally, the payout ratio should be 80% or lower (I prefer companies with 60% or less). This ratio is also listed on financial or online broker websites.
Why Don’t all Companies Pay a Dividend?
Dividend stocks that pay a dividend have a growing and stable income stream. But there are exceptions to this rule. Dividends are typically distributed by established firms that don’t need to continue reinvestment of their profits back into the business.
Take Starbucks for example. In the early days of going public, Starbucks pumped all of their profits into expanding stores across the entire world. They needed the extra cash influx to grow the business. This was the best place for their excess cash at the time. Once Starbucks was comfortable with the rate of its expansion, they opted to begin distributing a dividend to its shareholders. If Starbucks started paying a dividend right away, they would not have become such a strong company worldwide. This expansion and growth have rewarded shareholders many times more than a dividend would in the early years.
Tech, high-growth, or biotech companies don’t pay dividends usually because they need the payments to expand their growth. Once the dividend is established or increased, then investors should expect it to be maintained, even in tougher times. Other companies like Berkshire Hathaway, run Warren Buffet, also don’t pay a dividend. Warren believes he will find a better way to invest the excess cash than the typical investor would (psst.. he’s right).
What are the Different Types of Dividends?
There are a few other types of dividends. Two of which are:
Special Dividend
A special dividend is a one-time special distribution to shareholders (share the wealth!). Sometimes you will hear them called one time dividends. This is separate from the quarterly dividend cycle and is usually larger than the typical dividend. Companies issue special dividends when they have accumulated excess cash over the years.
Preferred dividends
Preferred dividends are issued to the preferred stock owners. This type of distribution doesn’t function like stock but rather like bonds. They come with fixed quarterly payments.
What is a Dividend Aristocrat?
Dividend aristocrats are many index constituents from the S&P 500 that have steadily increased their dividend payments for 25 years or more. The S&P 500 Dividend Aristocrat has been known to outperform the normal S&P 500 index. It shows lower volatility as a longer investment. These are blue chip long standing companies. Here are some famous dividend aristocrats:
| Ticker | Name |
| MMM | 3M Co. |
| AOS | A. O. Smith Corp. |
| ABT | Abbott Laboratories |
| ABBV | AbbVie, Inc. |
| AFL | Aflac, Inc. |
| APD | Air Products & Chemicals, Inc. |
| ALB | Albemarle Corp. |
| AMCR | Amcor Plc |
| ADM | Archer-Daniels-Midland Co. |
| T | AT&T, Inc. |
| ATO | Atmos Energy Corp. |
| ADP | Automatic Data Processing, Inc. |
| BDX | Becton, Dickinson & Co. |
| BF.B | Brown-Forman Corp. |
| CAH | Cardinal Health, Inc. |
| CAT | Caterpillar, Inc. |
| CVX | Chevron Corp. |
| CB | Chubb Ltd. |
| CINF | Cincinnati Financial Corp. |
| CTAS | Cintas Corp. |
| CL | Colgate-Palmolive Co. |
| ED | Consolidated Edison, Inc. |
| DOV | Dover Corp. |
| ECL | Ecolab, Inc. |
| EMR | Emerson Electric Co. |
| ESS | Essex Property Trust, Inc. |
| EXPD | Expeditors International of Washington, Inc. |
| XOM | Exxon Mobil Corp. |
| FRT | Federal Realty Investment Trust |
| BEN | Franklin Resources, Inc. |
| GD | General Dynamics Corp. |
| GPC | Genuine Parts Co. |
| HRL | Hormel Foods Corp. |
| ITW | Illinois Tool Works, Inc. |
| JNJ | Johnson & Johnson |
| KMB | Kimberly-Clark Corp. |
| LEG | Leggett & Platt, Inc. |
| LIN | Linde Plc |
| LOW | Lowe’s Cos., Inc. |
| MKC | McCormick & Co., Inc. |
| MCD | McDonald’s Corp. |
| MDT | Medtronic Plc |
| NUE | Nucor Corp. |
| PNR | Pentair Plc |
| PBCT | People’s United Financial, Inc. |
| PEP | PepsiCo, Inc. |
| PPG | PPG Industries, Inc. |
| PG | Procter & Gamble Co. |
| O | Realty Income Corp. |
| ROP | Roper Technologies, Inc. |
| ROST | Ross Stores, Inc. |
| SPGI | S&P Global, Inc. |
| SWK | Stanley Black & Decker, Inc. |
| SYY | Sysco Corp. |
| TROW | T. Rowe Price Group, Inc. |
| TGT | Target Corp. |
| CLX | The Clorox Co. |
| KO | The Coca-Cola Co. |
| SHW | The Sherwin-Williams Co. |
| UTX | United Technologies Corp. |
| VFC | VF Corp. |
| GWW | W.W. Grainger, Inc. |
| WBA | Walgreens Boots Alliance, Inc. |
| WMT | Walmart, Inc. |
Dividend Growth Investors
A dividend growth investor focuses on buying companies with a high growth rate in the dividend per share. They want the highest growth rate possible. Not only do they look for a high growth rate but a sustainable growth rate as well. Some companies will increase their dividend rapidly in order to get to a certain level. Once they hit that level they taper off the growth. These are to be avoided by dividend growth investors as they want sustainable long term growth.
Say for example a very popular fast-casual restaurant has a dividend yield of 1.2%. The restaurant is rapidly expanding, and they have a plan in place to increase the dividend by 10% each year. A long-standing manufacturing company has a dividend yield of 3.9%. It is quite possible that over the course of 30 years, the restaurant will collect more dividends than the owner of the manufacturing company. This is what dividend growth investors aim to do. Find these diamonds in the rough gems and pump their extra cash into them.
Dividend-Reinvestment Programs (DRIP)
DRIP investing is a wonderful gift that keeps on giving. It is a way for dividend investors to turn a snowball of an investment into an avalanche. You can have your stock brokerage firm do this for you. When a company pays you dividends, you can have those dividends automatically reinvested to buy more shares.
In the book, The Single Best Investment, Lowell Miller shows the difference between withdrawing your dividends at the end of each year and automatically reinvesting your dividends (DRIP). The study assumed that the dividend portfolio had a starting dividend yield of 4%, annual appreciation of 5%, and annual dividend growth of 5%. This was done over the course of 20 years with $1 Million Invested.
The person who Withdrew Income At the end of Each Year:
- Total Income: $2,242,081.00
- Total Appreciation: $2,207,135
- Annual Return from Income Alone: 18.4% or $184,410
- By the end of year 20 the stock value would have grown from $1 million to $3.2 million
The Person who used DRIP investing instead:
- Total Income: 4,440,234
- Total Appreciation: $8277,788
- By the end of Year 20, you would have an annual income of $533,472
- Your total return is 1,271%.
That is the amazing power of drip investing! It works so well because you are continually buying shares and those shares reap capital gains and dividends.
Stock Dividends
Stock Dividends refer to when a company pays additional shares based on a ratio. To put it simply, it is exactly what it sounds like. Companies give you more shares as a dividend. It is usually when a company wants to reward its investors but may not have the extra cash to shell out as a dividend.
Stock Dividends will dilute the share price. The great thing about a stock dividend is the options it gives the shareholder. Those who want income can sell, those who want long term growth can hold onto their newly acquired shares.
Dividend Yield Investors
Dividend Yield Investors take a slightly different approach. They look for large blue-chip companies that have the highest dividend yield they can find. This dividend must be seen as safe.
Usually, dividend yield investors are looking for long term safe security. They will trade off rapid growth for the high dividend yield. This is a passive income approach and can allow a steady stream of income.
Andrew is the host of The Personal Finance Podcast, a show that is changing the way you think about your money. His primary goal with the podcast is to bring as much value as possible to his listeners.
Andrew's favorite free financial tool he's been using since 2014 to manage his net worth is Personal Capital. Each month he uses their free Investment Checkup tool and Retirement Planner to track his investments and ensure that he's on the fast track to financial freedom.
His favorite investment platform is M1 Finance, a site that allows him to build a custom portfolio of stocks for free. It has no trading fees and is his preferred way to invest without having to lift a finger.
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