Investing in stocks has historically proven to be one of the best ways to build long term wealth. The dividends of a stock make up an attractive investment component for many investors, not only since it’s always a good feeling to regularly obtain an additional passive stream of income from the investments you own, but also because reinvested dividends can add to a greater return in the long run. But what exactly are dividends and how do they work?
What Are Dividends?
When you acquire stock of a company, you essentially become a shareholder of the business. One of the privileges as a shareholder is the right on your part of the dividends that a business pays out if the board of directors of the company decides to do so. A dividend is a proportion of the company’s earnings that is distributed to the shareholders as a reward for their ownership. In most cases, dividends are paid out in cash but dividends could also be paid out in form of stock.
Companies are not required to pay out any dividends. Therefore, it is completely up to the business and its owners to decide if it wants to continue paying dividends on a regular basis or to stop. Usually, dividend-paying companies tend to keep up a consistent dividend history in order to remain the contentment of shareholders. That being said, when a company falls into a period of tight cash flow or other financial hardship it may consider not paying any dividends in order to use the amount of cash for reinvestments.
As an investor, you will receive a dividend for each share that you own in the business. For instance, when you own 10 shares of a company that pays $4 in annual dividends, you will receive $40 in a year.
How Does a Business Pay out Dividends?
Deciding on a point in time at which dividends are paid and how they are being paid can be one of the most influential decisions that the board of directors has to make. Companies generally have several dividend payout policies to choose from, which define the dividend amount and the frequency at which dividends are being paid.
When the board of directors of the business agrees to pay a dividend to its shareholders, the amount and date of the dividend payment will need to be determined. Usually, companies tend to keep their dividend payouts in line with their schedule of disclosing financial reports.
How Frequently Are Dividends Being Paid?
In general, there is no official restriction of when and how frequently dividends are paid back since companies have the freedom to set up their own dividend policies. That being said, most corporations usually pay out dividends on a quarterly basis, meaning four times a year. Companies might also decide to set up dividend payments outside the traditional schedule. Some companies pay their dividends twice a year, once a year, or even every month. Major companies that pay out dividends on a quarterly basis include, for example, Apple Inc. (AAPL), Microsoft (MSFT), or Nike (NKE).
Sometimes, a company may also choose to pay a “special dividend”, which is a non-recurring payout outside the regular dividend schedule, and usually comes when current circumstances allow companies to return some profits back to their shareholders, for instance, when a business performs exceptionally well in a quarter and its earnings aren’t required to sustain further business operations.
Why Do Companies Pay out Dividends?
Companies can have different reasons why they might want to pay out dividends to shareholders. Generally, dividends are a good alternative way for businesses to return profits to their shareholders. The primary intention as a company to pay dividends is to reward shareholders for their ownership within the company and to encourage them to further stay within the business, while attracting potential investors to invest in the company. Oftentimes, companies try to maintain a consistent track record of dividend payments, even if recent profit results don’t necessarily suggest a dividend payment.
Generally, most growth companies don’t choose to pay any dividends in order to efficiently fund further growth which would result in profits for investors in form of capital gains, while more mature companies that aren’t expected to grow exceptionally in the future would rather conduct regular dividend payments.
Some of the major companies don’t prefer to pay any dividends to their shareholders such as Berkshire Hathaway (BRK-B), Amazon (AMZN), Facebook (FB), and Alphabet (GOOGL). Instead, they would rather use additional capital in order to optimize growth as much as possible. But if a business doesn’t see any better way to fully reinvest profits, they might as well just return profits back to the shareholder through a dividend.
While there are many investors who prefer to only invest in dividend stocks, high dividends don’t always necessarily represent a financially stable and healthy company. Therefore, you should always consider other factors besides the dividends of the underlying business before you make any investment decisions. Even if a dividend of a stock seems extremely attractive at first glance, the underlying business might have very poor returns in general.
That being said, the next time you encounter a business that is paying dividends, it can be beneficial to assess the dividend yield of the stock and the historical record of dividend payments. You can ask yourself the following questions. Is the company paying dividends on a consistent basis? Are dividends continually increasing, or do they heavily differ from each other? Is the dividend track record properly in line with the growth of the company?