What Is a Dividend? And Why Is It So Important?

What Is a Dividend?

A dividend is the distribution of some of a company’s earnings to a class of its shareholders, as determined by the company’s board of directors. Common shareholders of dividend-paying companies are typically eligible as long as they own the stock before the ex-dividend date.

How a Dividend Works

A dividend’s value is determined on a per-share basis and is to be paid equally to all shareholders of the same class (common, preferred, etc.). The payment must be approved by the Board of Directors.

When a dividend is declared, it will then be paid on a certain date, known as the payable date.

Steps of how it works:

1. The company generates profits and retained earnings
2. The management team decides some excess profits should be paid out to shareholders (instead of being reinvested)
3. The board approves the planned dividend
4. The company announces the dividend (the value per share, the date when it will be paid, the record date, etc.)
5. The dividend is paid to shareholders

Types of Dividends

There are various types of dividends a company can pay to its shareholders.  Below is a list and a brief description of the most common types that shareholders receive.

Types include:

• Cash – this is the payment of actual cash from the company directly to the shareholders and is the most common type of payment. The payment is usually made electronically (wire transfer), but may also be paid by check or cash.
• Stock – stock dividends are paid out to shareholders by issuing new shares in the company. These are paid out pro-rata, based on the number of shares the investor already owns.
• Assets – a company is not limited to paying distributions to its shareholders in the form of cash or shares.  A company may also pay out other assets such as investment securities, physical assets, and real estate, although this is not a common practice.
• Special – a special dividend is one that’s paid outside of a company’s regular policy (i.e., quarterly, annual, etc.). It is usually the result of having excess cash on hand for one reason or another.
• Common – this refers to the class of shareholders (i.e., common shareholders), not what’s actually being received as payment.
• Preferred – this also refers to the class of shareholders receiving the payment.
• Other – other, less common, types of financial assets can be paid out as dividends, such as options, warrants, shares in a new spin-out company, etc.

Important Dividend Dates

Dividend payments follow a chronological order of events, and the associated dates are important to determining which shareholders qualify to receive the dividend payment.

• Announcement date: Dividends are announced by company management on the announcement date (or declaration date) and must be approved by the shareholders before they can be paid.
• Ex-dividend date: The date on which the dividend eligibility expires is called the ex-dividend date or simply the ex-date. For instance, if a stock has an ex-date of Monday, May 5, then shareholders who buy the stock on or after that day will NOT qualify to get the dividend because they are buying it on or after the dividend expiry date. Shareholders who own the stock one business day prior to the ex-date—that is on Friday, May 2, or earlier—will receive the dividend.
• Record date: The record date is the cutoff date, established by the company in order to determine which shareholders are eligible to receive a dividend or distribution.
• Payment date: The company issues the payment of the dividend on the payment date, which is when the money gets credited to investors’ accounts.

Why Dividend Is So Important?

Five of the primary reasons why dividends matter for investors include the fact they substantially increase stock investing profits, provide an extra metric for fundamental analysis, reduce overall portfolio risk, offer tax advantages, and help to preserve the purchasing power of capital.

1. Growth and Expansion of Profits

One of the primary benefits of investing in dividend-paying companies is dividends tend to steadily grow over time. Well-established companies that pay dividends typically increase their dividend payouts from year to year. There are a number of “dividend aristocrats,” or companies that have continuously increased their dividend payouts for more than 25 years consecutively. Over the last 10 years (as of Jan. 28, 2022), the compounded annual growth rate (CAGR) of the total return for S&P Global Dividend Aristocrats was 2.72%.2

One of the basics of stock market investing is market risk, or the inherent risk associated with any equity investment. Stocks may go up or down, and there is no guarantee they increase in value. while investing in dividend-paying companies is not guaranteed to be profitable, dividend stocks offer at least a partial return on investment that is virtually guaranteed. It is very rare for dividend-paying companies to ever stop paying dividends, in fact, most of these companies increase the amount of their dividends over time.

Many investors fail to appreciate the huge impact dividends have on stock market profits. From 1980 to 2019, 75% of the returns of the S&P 500 came from dividends. This means the inclusion of dividend payments made up the majority of what stock investors have realized in returns on investment as compared to what their returns would have been without dividend payments.

2. Dividends Are Helpful in Equity Evaluation

Just as the impact of dividends on total return on investment, or ROI, is often overlooked by investors, so too is the fact that dividends provide a helpful point of analysis in equity evaluation and stock selection. Evaluation of stocks using dividends is often a more reliable equity evaluation measure than many other more commonly used metrics such as price-to-earnings, or P/E ratio.

Most financial metrics used by analysts and investors in stock analysis are dependent on figures obtained from companies’ financial statements. The potential problem with evaluating stocks solely based on a company’s financial statements is companies can, and unfortunately sometimes do, manipulate their financial statements through misleading accounting practices to improve their appearance to investors. Dividends, however, offer a solid indication of whether a company is performing well. In short, a company has to have real cash flow to make a dividend payment.

Examining a company’s current and historical dividend payout gives investors a firm reference point in basic fundamental analysis of the strength of a company. Dividends provide continuous, year-to-year indications of a company’s growth and profitability, outside of whatever up-and-down movements may occur in the company’s stock price over the course of a year. A company consistently increasing its dividend payments over time is a clear indication of a company that is steadily generating profits and is less likely to have its basic financial health threatened by the temporary market or economic downturns.

An additional benefit of using dividends in evaluating a company is that since dividends only change once a year, they provide a much more stable point of analysis than metrics that are subject to the day-to-day fluctuations in stock price.

3. Reducing Risk and Volatility

Dividends are a major factor in reducing overall portfolio risk and volatility. In terms of reducing risk, dividend payments mitigate any losses that occur from a decline in stock price. But the risk reduction benefit of dividends goes beyond that basic fact. Studies have historically shown that dividend-paying stocks outperform non-dividend-paying stocks during bear market periods. While an overall downmarket generally drags down stocks across the board, dividend-paying stocks usually suffer significantly less decline in value than non-dividend-paying stocks.

However, that trend did change of late. There have been three bear markets over the last 20 years, with dividend stocks outperforming during the first two, but during the most recent—amid the coronavirus pandemic—dividend-paying stocks underperformed.5

4. Dividends Offer Tax Advantages

The way dividends are treated in regard to taxes makes dividends a very tax-efficient means of obtaining income. Qualified dividends are taxed at substantially lower rates than ordinary income. Per the IRS, for individuals whose ordinary income tax rate is in the highest brackets (35% or 37%), qualified dividends are taxed at only a 20% rate. And for individuals whose ordinary income tax rate is below 12% to 35%, qualified dividends are taxed at 15%, and for those in the 10% or 12% tax brackets, they pay no tax on qualified dividends.

5. Dividends Preserve Purchasing Power of Capital

Dividends also help out in another area that investors sometimes fail to consider: the effect of inflation on investment returns. For an investor to realize any genuine net gain from an investment, the investment must first provide enough of a return to overcome the loss of purchasing power that results from inflation.

If an investor owns a stock that increases in price 3% over the course of a year, but inflation is at 4%, then in terms of the purchasing power of their capital, the investor has actually suffered a 1% loss. However, if that same stock that increased 3% in price also offers a 3% dividend yield, the investment has successfully returned a profit that outpaces inflation and represents an actual gain in purchasing power for the investor. The good news for investors in dividend-paying companies is that many dividend yields outpace inflation.