What are dividends?

Whether you’re an active trader who dives into the deep end of the market or a passive investor who rides out waves of volatility, dividends are one way your investments can make a splash in your portfolio. Whether or not stock prices ebb and flow with market changes, dividends are another way to generate a steady and stable investment income stream. Interested in learning more about what dividends are and how they work? Let’s jump in.

What is a dividend?

Dividends are a portion of a company’s earnings that are paid to eligible stock owners on a per share basis, typically on a regular cadence. So, if you own one share of a dividend stock or 100, you’ll receive a dividend payment for each individual share. You can generate investment income by investing in individual stocks that pay dividends, as well as dividend-paying funds, like many mutual funds or ETFs. While dividends can play a role in a diversified, fixed-income portfolio, payments aren’t guaranteed for dividend stocks and the amount paid may fluctuate.

Image titled "Dividends at work." Image depicts three examples of dividends earned if a company pays a $0.50 quarterly cash dividend per share of its stock. In example 1, Investor A owns 1 share of stock and will earn $2 annually. In example 2, Investor B owns 20 shares of stock and will earn $40 annually. In example 3, Investor C owns 100 shares of stock and will earn $200 annually.

Types of Dividends

While not all companies pay dividends, about three-quarters of those on the S&P 500 index do, and they can do so in a couple different ways. If you own common stock, which is the most popular form of stock investors buy from publicly traded companies, your dividends will likely be …

Stock dividends: Dividends paid via additional shares of a company’s stock.

Cash dividends: The most popular form of dividends. They are paid in cash that’s typically deposited directly into your investment account where it can be withdrawn or reinvested.

Special dividends: Unlike regular dividends, these aren’t paid on a recurring basis. Companies may issue them individually or along with regular dividends. These extra payments for common stockholders are typically larger and usually occur when a company has recently reported exceptionally strong earnings or received a major windfall through a sale or other event.

If you own preferred stock, dividends work a bit differently. Preferred stocks function similarly to bonds and they issue fixed-amount, regular dividend payments — meaning investors know just how much they’ll earn in dividend income each year. If a company distributes excess earnings through dividends, preferred stock owners receive payments first before common shareholders.

How are dividends determined, and how often are they paid?

It’s up to a company’s board of directors to decide how much, when and how often dividends are paid. Boards develop dividend payout policies based on factors like projected growth, income stability, reinvestment opportunities and competitors’ policies.

Companies often choose to issue dividends on a monthly, quarterly or annual basis. After a dividend payout is approved by the board, companies announce the dividend, its amount, the ex-dividend date (we’ll explain what this is shortly) and the payment date to shareholders on what is called the declaration or announcement date. Shareholders must approve this before payments can be made.

The ex-dividend date, or ex-date, is highly important for shareholders to understand as it determines who is eligible to receive dividends. If you own a stock by the ex-date, you’re qualified to receive the payment. But if you buy a dividend stock on or after the ex-date, you aren’t eligible for the dividend payment. And if you own the stock on the ex-date but sell it before the payment date, you’ll still receive the dividend.

Why do companies pay dividends?

Dividends can help companies build trust with shareholders, since they’re a positive sign of financial health — demonstrating the company has the means to share earnings with investors rather than needing to put the money back into the business. Well-established companies are more likely to pay dividends than less mature, high-growth ones (like startups) that rely on reinvesting capital.

Why invest in dividend stocks?

While some think of dividends as a way for retirees to use the market as a source of income, dividend stocks can be a smart asset for all investors to consider. Dividends are an additional way to make a profit in the stock market besides relying on capital gains, since they can be reinvested — manually or through a dividend reinvestment program (DRIP) — to further expand your position in the market.

How to Evaluate Dividends

Before you invest in a dividend stock, mutual fund or ETF, you’ll want to research a few factors. Begin with how long a company has made dividend payouts and if the amount per share has increased over time — a sign of financial strength — by reviewing the dividend per share (DPS) metric.

Pro tip: Look for “dividend aristocrats,” or stocks that have increased dividends for 25 or more consecutive years. This typically indicates strong financial standing and that they’re more likely to continue paying regular (and rising) dividends.

Next, consider dividend yield, a metric used to compare multiple dividend stocks. It measures how much a company pays in dividends in relation to its stock price as a percentage. Calculate this by dividing annual dividend by price. While high dividend yields (4% or above) may sound appealing, it’s a good idea to do extra research into stocks with these yields, as they may not be sustainable.

Finally, examine a stock’s dividend payout ratio, which indicates how much of a company’s earnings are paid out to shareholders. If a company pays out close to 100% of its profits, its dividend is likely unsustainable and won’t be able to withstand a tough financial year. Payout ratios of 80% or lower are typically more sustainable in the long run. You can find payout ratios and dividend yields through your broker’s website, like Ally Invest‘s.

Dividend and Conquer

When the stock market is booming or if volatility muddies the waters, dividends can be an additional source of investment income. While they’re never guaranteed, dividend cash or stock payments can help buoy your portfolio and provide you with more capital to invest or use how you choose.

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