Common Stock Dividends

There are 2 ways that investors can earn a profit by buying stock: by buying the stock low and selling it higher, and by receiving dividends. While most companies—especially small, growing companies—do not pay a dividend, most large, profitable companies do by necessity, because there is a limit to how large a company can grow, and so the only way to maintain its stock price is by paying a dividend.

However, there are several advantages to stocks paying a dividend over those that don't. Dividend-paying stocks provide a more certain income than what price appreciation alone offers. When the stock market declines, holders of dividend-paying stocks still receive an income, and the dividend helps to maintain the stock price even in a down market. And, often, the dividend plus the capital gains of a dividend-paying stock is greater than the capital gains of many stocks that do not pay a dividend. In fact, dividends have accounted for about 40% of the total return of the stock market since 1928!

Should the Company Pay a Dividend?

Whether a dividend will be paid depends on the profitability of the firm. While a firm does not have to earn profits to pay a dividend, it would generally be a bad decision for an unprofitable firm to pay dividends. And without profits, the future payment of a dividend would be in jeopardy.

The board of directors decides if and when a stock dividend will be paid, and how much. The board will generally consider the company's financial position, both now and in the future, and the opportunity costs of paying a dividend. If the company can use the money to grow faster, then a dividend probably will not be paid. But if a company is both large and profitable, then it could pay some portion of its earnings as a dividend, since it becomes more difficult for a large company to grow ever larger. Hence, without the payment of a dividend, investors will shun the stock, since there is little chance to profit from price appreciation, and the stock's price will collapse.

Besides size, the largest factor in considering a dividend payment is the company's common earnings per share (EPS), which is the after-tax income of the company minus the dividends paid to preferred shareholders divided by the number of common shares outstanding.

Earnings Per Share =Net Profit – Preferred Dividends
Number of Outstanding Common Stock Shares

If the common earnings per share is high and likely to remain high, and if the company is too large to grow much larger, then the board of directors will probably decide to pay a dividend.

Will the dividend be reliable? The key to answering that question is to look at free cash flow from operations, or in the case of real estate investment trusts, funds from operations. If cash flow is insufficient, it is unlikely to continue paying dividends, and when dividends are discontinued, the stock price will decline.

How the Dividend is Paid

When the board of directors declares a dividend, which is on the declaration date, they also specify the date of record and the payment date. The date of record is the date when a stockholder must be a registered owner of the stock—a holder of record—to receive the dividend. The payment date (aka payable date) is when payment is actually made—generally about 3 weeks after the date of record.

Because it takes 3 business days to settle a stock trade, the date of record determines the ex-dividend date, which is 2 business days earlier. The ex-dividend date is the 1st day in which the stock trades without the recently declared dividend. In newspaper listings, a stock is marked with an x to indicate that it is ex-dividend. An investor who buys the stock during the ex-dividend period will not be entitled to the recently declared dividend.

The price of the stock increases steadily by the amount of the dividend until the date of record, then drops by the same amount on the ex-dividend date. This happens because investors are willing to pay more if they are expecting to receive the dividend, which offsets the increased price. Moreover, open buy and stop sell orders are also usually reduced by the dividend amount on the ex-dividend date.

Dividend Yield and the Dividend Payout Ratio

Although the dollar amounts of dividends are specified by the board of directors, investors often want to know how the dividend compares with other investments. The dividend yield, which is the dollar amount of the dividend divided by the common share price, yields a percentage allowing the investor to compare the stock to other investments, especially if the investor is primarily concerned about current income.

Dividend Yield = Annual Dividends Per Share ÷ Current Stock Price

Example: If a stock pays a $1 quarterly dividend and the current stock price is $40 per share, then:

Dividend Yield = $1 × 4/$40 = $4/$40 = 10%

Another concern of investors when considering a dividend-paying stock is whether the company can continue paying the dividend or even increase it over time. A company can only pay a dividend over an extended period if it is highly profitable. If a company is only minimally profitable, it will probably withhold the payment of dividends during economic downturns. And a company can only increase the dividend if its earnings grow. The dividend payout ratio, which is the dividend per share divided by the common earnings per share, is a good indicator of whether a company can continue to pay the dividend and even increase it in the future.

Dividend Payout Ratio =Dividend Per Share
Common Earnings Per Share

For example, if a company earns $8 per share and pays $1 per share quarterly as a dividend, then its:

Dividend Payout Ratio = 1 × 4/8 = 4/8 = 50%.

If a company's dividend payout ratio is greater than 60%, especially over a long time period, it will probably not increase its dividend for the foreseeable future, and it may have to lower it or even suspend it in hard economic times because most of its earnings are being paid out as dividends.

Investment Tip: A stock with a high dividend yield but a low payout ratio is probably underpriced and is more likely to maintain or even increase its dividend over time, thus making it a good investment prospect.

Dividend Payment—Cash and Stock Dividends

There are 2 common types of dividends. Cash dividends are dividends that are paid in cash, and are the most common type of dividend. Stock dividends are paid in extra shares of stock instead of cash. Sometimes, however, a company will distribute a different type of dividend, such as the stock of a spin-off company.

Whether the dividend is paid as cash or as stock, the payment of a dividend reduces the price per share of the company. If the dividend is paid as cash, then the company will have less cash, reducing its value, and, therefore, its value per share. If the dividend is paid as stock, then there are more shares outstanding, but the value of the company has not increased; therefore, the company's value per share is reduced. For example, if a company pays a 10% stock dividend, then it will distribute 1 share of stock for every 10 shares that the holders of record own, and the total number of outstanding shares will also increase by 10%. However, the main advantage of a stock dividend for the company is that the retained earnings can all be reinvested for greater growth. The main advantage of a stock dividend for the stockholder is that no taxes have to be paid on the stock dividend until the shares are sold.

Taxation of Dividends

Dividends are subject to double taxation. The corporation must pay taxes on the income used to pay dividends and the shareholders must pay taxes on cash dividends. There is no tax due on stock dividends until they are sold.

Dividends were originally taxed as ordinary income, but the Jobs and Growth Tax Relief Reconciliation Act of 2003 lowered the tax to 0% for stockholders in the lowest 2 tax brackets, 15% for the higher tax brackets, except the top 39.6% bracket, which is 20%.

Many large corporations provide dividend reinvestment plans (DRIPs) for their stock. These programs allow investors to buy company shares directly from the company, without any transaction costs, such as brokerage commissions, or the need to buy round lots, and the company will reinvest the dividend into additional company stock. In fact, dividends can be used to buy fractional shares of stock. Most companies also allow partial participation where the stockholder can specify the amount to be reinvested and the amount to be paid as cash.

DRIPs are usually administered by large banks, who issue quarterly reports to the DRIP participants, stating the number of the shares in the account, the number acquired, and the prices paid. The bank may charge an annual fee for the service, but, in many cases, the company will pay it. The company may issue the stock directly, often times at a discount, or its bank may go out into the open market and buy the shares, in which case, the DRIP investors, will pay the market price.

While DRIPs are excellent investment vehicles, they differ from stock dividends in that taxes are due on the reinvested dividends in the year that the dividends are earned. More info: Taxation of Dividends.