What Are Dividends and How Do They Work?

What are Dividends?  

When companies make money, they give away part of these earnings to their shareholders. These declared earnings are called dividends. They come in the form of money (cash), stocks and a less likely form of assets.

The company has to be in a secure position to declare dividends. Once the declaration is made, then they issue a press release stating the Dividend Per Share, or how much they are giving out per share held.

Dividends are also sometimes declared on specific class of shares. Sometimes the company pays out preferred shareholders, and sometimes they pay out both preferred and common shareholders. They are not obliged to pay out dividends until they make a formal declaration.

How Dividends work (and work for you)

Hang around stock brokers long enough and someone’s bound to say it: dividend. No, they’re not talking about sixth-grade math problems. Dividends are a way to make money on the market, over and above the usual method of picking winning stocks. With a little solid info, and some practice, you too can put dividends to work for you.

Here’s how!

To explain dividends, let’s start with the most basic of investment ideas: you hitch your fortunes to a company — you buy stock in it — with the hopes that its future value will increase your wealth. For example, you hope your $1,000 investment in a company today will be worth $1,500 down the road. That’s the old buy-low/sell-high strategy.

Now consider this.

In addition to selling stock that’s grown to be worth more than what you paid for it, you might also look for stock that pays you to own it. That payout, friends, is what the pros mean when they say “DIVIDEND.” A company, as a reward for holding its stock, actually pays you from time to time. No one needs to sell a thing.

Let’s look at the how’s and why’s of what makes that system work.

Why Would a Company Pay You To Own its Stocks

Companies that are making a profit frequently find themselves faced with a very important qurstion; what should we do with all that newly earned money?

Do they invest in the further growth of the corporation? Do they reward investors for supporting the company? Or, do they do a bit of both? Turns out they’re both good for you. Here’s how it works.

  • The Reinvestment Strategy: Some companies simply see reinvestment as a greater benefit for investors. Make the company more attractive to the market and stock values increase. Investors then reap the rewards at their personal points of sale and the company keeps its profits in-house. Everybody wins!
  • The Payout Method (Dividends): Dividends are seen as adding value to the stock, as a way to attract new investors. Companies declare that they’re going to pay a dividend and then they set a date for disbursal. That will bring investors calling. Usually, you’ll need to own the stock for a certain number of business days before the announced payment date to actually receive the dividend. When stocks are bought and sold after such a cutoff date, it’s typically the owner who held the stock before that date who gets the dividend.

Here’s a hypothetical example that should help make things crystal clear.

Say you invest in (let’s call it) “Wizard Bean Coffee”. what-are-dividends

A national restaurant chain that carries Wizard’s grounds has a monster year of expansion… the little coffee company could suddenly be in a position to:

  • Sink a great deal of revenue into new facilities, increase trucking capacity, or aggressively brand its way into a wider share of the coffee bean market. As the company grows, its stock becomes more valuable. More people are willing to spend more money to have a piece of our fictional Wizard. In that case, after a quarter or so, your $3 stock might be worth $8–$10. Winning!
  • On the other hand, maybe Wizard thinks it wants to keep “small,” “crafted,” and “quality” as its operative key words. Good for them. It may still want to draw new investors, however. It can do this, not by changing its business recipe, since it already works, but by announcing a payout to the existing investors who’ve helped it succeed. Again, investors take notice of these little details. So, in this case, there is modest or no expansion in its infrastructure, but you get a note from Wizard that a crate of its delicious French Roast is on its way — or maybe it’s a thank-you in the form of a bankable check.

What Does A Dividend Pay, Exactly?

How much you earn in dividends depends on the kind of stock you own. It can vary quite a bit. If you buy what’s called preferred shares, you’ll usually know what your dividend payment is going into the deal. It’s set at the time of purchase. If you own common shares, however, that dividend amount is set at the company’s discretion.

Dividend payouts can come in different forms as well. Here are some of the various methods:

  • Cash: A straightforward monetary payment. This is the most common form of dividend payout. For example, ExxonMobil paid out 47 cents a share in November 2011. Over the four quarters of the year, the company totaled about $1.85 in payout per share. Owning a heap of shares certainly helps, as you’re multiplying the dividend payouts by the amount you’re holding.

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  • Property: A company can also issue dividends in the form of inventory or other physical holdings. You might get computers or electronics from one company, grosses of raw materials from another, or even something like a car from an auto manufacturer. Obviously you’ll have to be a major shareholder for these kinds of payouts.
  • Stocks: Distributions can also come in the form of stocks themselves, sometimes paid out as a fraction of new stock for every full share you already own.

Strategies to Succeed in the Dividend Game

  • Diversify: To play the dividend game well, think diversification. Consider it this way: invest only in dividend-bearing Wizard stock, and if the coffee-bean market suffers a natural disaster then your dividend yields go swirling down the drain with the rest of the black stuff. Don’t sink everything into one industry.
  • Dig Deeper: Read the deeper text of a company’s payout history. A history of steady and steadily increasing dividends might look good at first blush, but check the payout ratio: the numbers that tell you how much of the company’s earnings are going into the payments. One tool to do this can be found at Dividend.com. Plug in a stock symbol to see its historical payout data.

So, a little forethought, some advanced research, and the discipline to buy early in a company’s life-cycle and hold on until it reaches profitability … put these ingredients together and there might be some handsome dividends in your future.


To learn more about dividends and how stocks are priced, check out the our course Going Deeper with Stocks!

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One response to “What Are Dividends and How Do They Work?”

  1. […] Dividend investors don’t. They demand their stocks pay them, in cash. The easiest way to measure this is through dividend yield. […]

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