Investing in the stock market can be an exciting proposition. Stocks provide an opportunity to make your money work for you. In fact, there are two ways to earn money when you own a stock.
The first is through capital appreciation, which is to say that the value of the stock you own increases. As a company becomes larger and more profitable, your tiny slice of the pie hypothetically gets larger as well. However, in order to make a profit from the stock, you’ll have to sell it at a higher amount than you initially paid.
The second way to make money on a stock is through a dividend payment.
What is a dividend? That’s when a company periodically gives its shareholders a cash payment—it may also come in the form of more stock shares. The size of that dividend depends on the company’s dividend rate and how many shares you own.
Although not all companies pay dividends, there are some investors who choose to target stocks that do pay dividends.
When investors talk about dividend payments, they are generally referring to the dividends paid out on the common stock of public companies.
A public company is one that offers shares of ownership for sale to the general public that can be bought and sold on an exchange. A stock represents some small fraction of ownership in that company, allowing investors to partake in potential future profits.
A dividend payment could also refer to payments made by a private company to its owners or private shareholders, but that is not the most common use of the phrase. This article will stick with the public company, common stock scenario.
What Is a Dividend Payment?
A dividend payment is a portion of a company’s profits paid out to the shareholders of that company. Dividends can come in the form of cash or as additional stock.
The former is called a cash dividend. The latter is called a stock dividend.
Dividend payouts can happen on a fixed schedule, such as once per quarter or once or twice annually, although a company can issue them at any time. Unscheduled or spontaneous dividends are sometimes known as special dividends or extra dividends.
A company is not required to pay out a dividend. There are no established rules for dividends; it’s completely up to the company to decide if and when they pay them. Some companies pay dividends like clockwork, and others never do.
Even if they are paid out on a regular schedule, dividends are not guaranteed. A company can skip or delay dividend payments as needed. For example, a company may withhold a dividend if they had a quarter with negative profits.
However, such a move may upset the shareholders of that company, and that could ultimately reflect in the share price.
When a dividend is declared by a company, shareholders are usually notified by a press release, and the news quickly becomes public. By this time, the company will have set a record date. If you own that stock on the record date, you are entitled to the dividend payment. (The record date is not usually the payable date.)
The day following the record date is called the ex-date, which is the day that the stock begins trading what is called the ex-dividend. That means that if you were to buy a stock on or after an ex-date, you are not entitled to receive the most recent dividend payment.
Dividends can be paid out via a check, a deposit into the account where the stock or fund is held or sometimes be reinvested into the stock or fund. To find out how your dividend will be paid out, check with the financial institution where you invest.
What Is a Dividend Yield?
A dividend yield (or dividend rate) is a financial ratio that shows how much a company pays out in dividends each year relative to its share price. A stock’s dividend yield can be useful for comparing stocks that trade for different dollar amounts and with varying dividend payments.
The amount you receive in a dividend payment is usually based on the number of shares you own. For example, if a stock pays a quarterly dividend of $1 per share and you own 50 shares, you would receive a dividend of $50 each quarter.
But the absolute dollar value of a dividend may not be the most important element. Investors also consider how much they paid for the stock. For example, consider two stocks that both pay a $1 quarterly dividend.
One of these stocks costs $95 per share and the second costs $165. The stock that costs $95 has a better dividend yield or dividend rate than the one that costs $165.
Here’s how to calculate the dividend yield for a stock:
Annual Dividend ÷ Stock’s Price Per Share = Dividend Yield
Let’s use the example from above to determine the dividend yield for each. Remember, both companies are offering a $1 quarterly dividend, which is a $4 annual dividend.
The company with the $95 per share price has a dividend yield of 4.2% ($4 annual dividend ÷ $95 per share = 4.2%). The company with the stock valued at $165 has a yield of 2.4% ($4 annual dividend ÷ $165 per share = 2.4%).
While this formula is useful for comparing dividend yields, there may be other factors to consider when deciding on the better investment. There are many reasons that a company could have a high or low dividend yield, and some insight into why is necessary for analysis.
Why Do Investors Buy Dividend Stocks?
In general, investors would only buy shares of a stock if they believed that investment would be profitable at some point in the future. Therefore, the chance to earn dividends will likely factor into their overall analysis.
It may be helpful to understand that when you hear the performance of the stock market (or a stock) quoted as an annualized number, this figure usually includes both the average price increase of the stock market and the dividend payout.
For example, you could hear, “These stocks are up 10% on average.” It’s possible this could mean that 7% of the 10% is from capital appreciation and 3% from the dividend payment.
Stocks whose prices go on meteoric rises are exciting to watch and get a lot of airtime in the media, but the dividend yield is also an important element of overall returns. The dividend should be considered in an analysis of stocks. Together, price appreciation and dividends make up a stock’s total return.
There are a number of reasons that investors target stocks with a high dividend yield. For one, they could be doing it for strategic reasons.
For example, perhaps their independent analysis shows that stocks with substantial dividends will fare particularly well in the current market environment or that dividend-paying stocks will perform better than average in the foreseeable future.
And then others may simply be including the dividend payout as part of a greater overall analysis on whether to buy a stock. Companies paying a similar dividend could be different in many other ways, and how much dividend a company pays should be considered along with other factors.
Other investors may target dividend-paying stocks as a way to create income. They may be doing this as a way to replace a salary during retirement or to supplement their current income. Investors who are following an income-producing strategy tend to favor dividend-paying stocks, government and corporate bonds, and real estate investment trusts (REITs).
Dividends and Income Taxes
Another reason that investors may target dividends is because they may receive favorable tax treatment depending on their situation, how long they’ve held the stock, and where that stock is held.
Qualified dividends are taxed at long-term capital gains rates, which are lower than ordinary income tax rates. Depending on your income, qualified dividends are taxed at a rate between 0% and 20%. Non-qualified dividends are typically taxed at the same rate as a person’s ordinary income tax rate.
What makes a dividend qualified? This part can get a bit confusing. For the IRS to consider a dividend qualified, they require that the stock investment be held for more than 60 days during the 121-day period that begins 60 days prior to the ex-dividend date, the day after a corporation’s board declares a dividend payment to shareholders.
Basically, stocks that are held for a short time frame may be subject to a higher tax rate. Stocks held for longer are subject to the lower tax rate. You can find more information about qualified and non-qualified dividends through the IRS.
Your dividend payments are summarized on the Form 1099-DIV, which is sent out by your financial institution. And if you have multiple bank or trading accounts and receive dividends from many financial institutions, you should receive a Form 1099-DIV from each institution.
Note that if you own stocks through a qualified retirement account specifically designed for retirement planning, such as a traditional or Roth IRA, no annual taxes are assessed on dividend payments and capital appreciation, since these accounts enjoy tax-free growth, although you may be taxed upon withdrawal.
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