Understanding Dividends: A Beginner's Guide to Stock Income

Building a stronger financial future often involves some form of investing. But for beginners, discovering where, when and how to invest their money can be tricky. When investing in the stock market, an important option to consider are dividend stocks.

Dividends, Defined

Dividends are the regular payments shareholders receive from a company’s corporate earnings as a reward for investing. These payments are paid per stock on a regular basis and are one of several ways investors make money.

For investors, the value of dividends is obvious. But why do companies choose to make these payments? The answer may depend on the individual company’s goals, but dividend payments tend to build trust with investors and reflect positively on the company’s brand, as they are an indication of positive profits.

But it’s important to note that dividends are not available for every stock. Larger, established companies are more likely to offer dividends as they have more predictable profits. Investors who are looking to maximize dividends should therefore do their research ahead of time to find the best dividend-paying stocks.

How Dividends Work

Companies can pay dividends as either cash or additional shares, and in some cases, investors may even be able to reinvest received dividends at a discount.

The exact amount of a dividend payment is determined by the company’s board of directors based on company performance. The dividends are paid per share of stock, so the more shares you own, the more money you’ll receive. For example, let’s say you own 20 company shares and the company pays $2 per stock in annual dividends. In this situation, you would receive $40 in a year, typically spread over quarterly or monthly payments.

But in order to benefit from these dividend payments, there are a handful of things you must consider, from important dates to unavoidable taxes.

Finding Dividend Stocks

As we’ve discussed, established companies are most likely to offer regular dividend payments, such as Apple, Target or Disney. Most frequently, dividends are paid from a company’s common stock – but dividends are also offered with certain exchange traded funds (ETFs) and dividend mutual funds. Lists of the highest paying dividend stocks are frequently found on financial sites, including online brokerages.

Ex-Dividend Date

Do all shareholders earn dividends? The answer will depend on when these shareholders purchased their company stocks. Investors must own stock before the ex-dividend date in order to receive the dividend.

Investors who purchase stock after this date will not receive dividend payments, so it’s crucial that investors look at this before purchasing stocks. However, investors who sell a stock after the ex-dividend date are still eligible to receive the dividend if the stock was purchased before this date.

Taxes On Dividends

Dividends are considered taxable income – but depending on how and when you own the investment, the exact tax rate you pay may change drastically. Typically, stock held for more than 60 days before the ex-dividend date is considered a qualified dividend. Dividends from shares that were not held long enough may be considered nonqualified and will therefore be taxed at a higher rate.

The tax rate on qualified dividends is 0%, 15% or 20% depending on your income bracket and filing status. Nonqualified dividends are taxed at the same rate as your regular income. This means for both qualified and nonqualified dividends, investors in higher tax brackets will pay more in dividend taxes.

Types Of Dividends

Dividends are easy enough to understand, but as simple as they may seem, it’s important to remember there are multiple types – some of which do not involve cash payments. Keep reading to learn more about these different types of dividends and what you can expect as a potential investor.

Cash Dividends

By and large, the most common dividend type is cash dividends. With cash dividends, companies pay investors a predetermined amount on a specific date, referred to as the date of payment.

Stock Dividends

As the name implies, stock dividends are dividends received in the form of company shares rather than cash. This allows the company to reward shareholders for their investment without tapping into the company’s earnings.

The exact amount of stock an investor receives in these dividends depends on their existing shares, as the dividends are distributed at a percentage per share. For example, if you own 100 shares and the company issues a stock dividend of 3%, you’ll receive three additional company shares.

Special Dividends

While traditional cash dividends are paid on a standard schedule – typically quarterly or monthly, depending on the company – special dividends are nonrecurring. Special dividends are often larger than normal dividends and usually occur when the company has some sort of special event, such as an asset sale.

Preferred Dividends

Preferred dividends are paid to preferred stockholders – a group of investors who own preferred shares, which typically pays higher dividend rates than common stock. In the event of a company being unable to pay all dividends, preferred dividends take priority over traditional ones.

How To Profit From Dividend Stocks

To capitalize on dividend stocks and maximize your potential profit, there are a few things potential investors should look for.

Compare Dividend Stocks

Comparing stock from different companies is always the first step with investing, but it’s especially important with dividend stocks, as company performance is one of the key factors in determining dividend rates.

Potential investors can begin their search on a number of financial sites, including online brokers, who typically include a list of high-dividend stocks. But your research shouldn’t stop there! Analyzing the following factors, such as the dividend yield and payout ratio, can provide deeper insight into the stock’s performance to better protect your investment.

Monitor Dividends Per Share (DPS)

DPS refers to the number of declared dividends a company will issue for each individual share. You can calculate a stock’s DPS by looking at the total number of dividends paid by the company with the number of outstanding shares.

A stock’s DPS is equal to its total dividends paid divided by the number of shares. It’s an important number to monitor because an increasing DPS indicates strong stock performance.

Analyze Dividend Yield

A dividend yield is the estimated ratio of money a company pays its shareholders divided by its current stock price. It’s displayed as a percentage and indicates the return on a stock investment. High dividend yields are attractive as they indicate positive stock performance, but potential investors should be sure to consider this alongside other factors when choosing stock, as dividend data may be outdated.

Check The Dividend Payout Ratio

The dividend payout ratio is the percentage of earnings paid to shareholders in dividends annually and is sometimes referred to simply as the payout ratio. This ratio is calculated by taking the yearly dividends paid divided by the company’s net income.

So why is this number important? While some companies will pay out all earnings to shareholders, others may only pay a small portion. For example, newer startups are likely to have low payout ratios, as they need to retain their earnings to grow. Analyzing the payout ratio can indicate the company’s level of maturity, which will also play a role in the appreciation of share prices over time.

Know How Much To Invest

Once you find a dividend stock, the next step is to decide how much money to invest. This process should begin with a general analysis of your finances, including your savings and monthly budget, to determine how much cash you’ll put forward. Once this has been determined, it’s time to decide where these funds will be invested.

The expression “don’t put all your eggs in one basket” comes to mind, as diversification is crucial when you buy individual stocks. Investing all your money in one stock is risky, as the decline of that stock will significantly impact the return on your investment. This is why investing in multiple stocks, typically across multiple industries, is so important.

Consider Reinvesting Dividends

Instead of receiving dividends as cash, many companies allow shareholders to reinvest their dividends – essentially using your dividend payment to buy more company stock. Whether this is the right option for you will ultimately depend on the company’s success and your financial goals, but keep in mind that while this option may boost your long-term returns, it also means you’ll be earning less money along the way.

The Bottom Line: Dividends Can Be A Path To Passive Income

The goal of any investment is to make a long-term profit, but by choosing to invest in dividend stocks, investors may be able to build consistent passive income as well. To take the next step, explore good stocks to buy today!