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What are dividends and how do they work?

April 21, 2022  • 8 min read

What we'll cover

  • How dividends are paid to shareholders

  •  Types of dividends

  • How to evaluate adding dividend stocks to your portfolio

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. But what are dividends and how do they work? There are many types of investments, so why invest in dividend stocks?

Let's find out if dividend investing makes sense for you.

What is a dividend?

Dividends refer to a portion of a company’s earnings that are paid to eligible stock owners on a per share basis, typically offered to investors on a regular cadence (for instance, quarterly).

In other words, for every share you own of a dividend stock, you’ll receive a dividend payment whenever one is issued. 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 . Remember, 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.

How do dividends work?

If you own stocks of companies that pay a dividend, you can receive a dividend payment. However, it's important to note that not all companies offer dividends. As long as the company commits to paying a dividend continuously, you'll receive dividends every year. An ordinary dividend refers to a regularly scheduled payment made by a company to its shareholders.

Here's how it works: Let's say you buy 200 shares of a company for a share price of $5 each — that’s a total of $1,000 invested. Each share pays you $0.50 in dividends quarterly. You'd get $400 in dividend payments over one year.

You can do what you want with your dividend returns, such as reinvest them back into more shares, or you can spend or save the money you receive.

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

Even though we said that 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. Let's take a look at a few types of dividends.

Stock dividends

Stock dividends are dividends paid via additional shares of a company’s stock — meaning, the company would give you extra shares of stock.

Cash dividends

As the most popular form of dividends, cash dividends are dividends paid in — you guessed it! — cash. The money is typically deposited directly into your investment account where it can be withdrawn or reinvested.

Special dividends

Unlike regular dividends, special dividends aren't dividends paid out on a recurring basis. Companies may issue them individually alongside 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 — kind of like a bonus payment.

If you own preferred stock, dividends work a bit differently. Preferred dividend stocks function similarly to bonds. They issue fixed-amount, regular dividend payments, which means 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.

Property dividends

A property dividend means that a company gives you property instead of cash or cash equivalents. A company might give you real estate or other physical assets, for example.

Liquidating dividends

When a dividend paying company is shutting down or partially liquidating, it may choose to distribute cash or other assets to shareholders. This is called a liquidating dividend.

Scrip dividends

A scrip dividend refers to a company that gives its shareholders the choice of receiving a dividend through either cash or company stock. Think about what you’d prefer: Would you rather receive a cash dividend or more company's stock? It's a good idea to have this in mind, so you can make the right decision based on your individual goals.

4 important dates for dividends

In the case of dividends, there are four main dates to know: the declaration date, ex-dividend date, the record date and the payment date. Let's go over these in detail.

Declaration date

The declaration date, or announcement date, is an easy one to understand. It's the date on which the board of directors of a company authorizes, or declares, that dividend payments will go to shareholders.

Companies have to pay attention to a wide number of factors before they choose the date dividend payments that will go to shareholders, including retained earnings, which are historical profits earned by a company, minus any dividends it paid in the past.

Ex-dividend date

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.

Record date

The record date refers to the final date that you must be on a company's books as a shareholder in order to receive the dividend. The company sets this date as a last date that shareholders are eligible to receive an upcoming dividend distribution.

Payment date

Most shareholders probably like this date best: The payment date signals the date in which eligible shareholders will get paid by companies.

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 and the payment date to shareholders on the declaration date. Shareholders must approve this before payments can be made.

Why do companies pay dividends?

Dividends can help companies build trust with shareholders, since they’re a positive sign of financial health. Dividends demonstrate that 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 also be an asset for any investor to consider as part of a diversified portfolio. Although you're not guaranteed a dividend payout, since it ultimately depends on the company, dividends can be an additional way to make a profit in the stock market besides relying on capital gains, since dividends can be reinvested —  manually or through a dividend reinvestment program (DRIP).

How to evaluate dividends

Before you invest in a dividend stock, mutual fund or ETF, you’ll want to research a few factors.

Dividend history. 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 the Dividend Aristocrats, or stocks that have increased dividends for 25 or more consecutive years. This might indicate strong financial standing and that they’re more likely to continue paying regular (and rising) dividends.

Dividend yield. This 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 the 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.

Dividend payout ratio. This number 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 Ally Invest.

Dividend tax rate. The qualified tax rate is 0%, 15% or 20%, depending on your taxable income and filing status. (Pay attention to taxes on unearned income, qualified dividends, capital gains and financial ratio of dividend stocks in relation to your goals, risk tolerance and time horizon.)

What can you expect from Ally Invest?

Ally Invest's dividend reinvestment plan (DRIP) is a program that allows cash dividends you receive to purchase additional whole or fractional shares of your investment automatically. You can accumulate stock over the long term without paying commission fees.

As an Ally Invest customer, you can enroll in our dividend reinvestment program online from your account settings.

Dividend and conquer

When the stock market is surfing a high way 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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