What is a Dividend and How Do They Work?

A dividend is a payment in cash or stock that a company distributes to its shareholders.

Dividends originate primarily from the company’s earnings after accounting for all expenses, including taxes.

When a firm earns a profit, it typically has two options: retain the cash for future business investment or distribute it to its shareholders. 

If it chooses the latter option, the payment is known as a dividend

Essentially, dividends are a way for shareholders to partake in a firm’s profits.

While both public and private firms can issue dividends to their shareholders, the focus of this article will be on the former since they’re the most accessible to ordinary investors.

A company must have cash available to pay a dividend, which means it must generate a net profit from its business operations.

Net profit or earnings is the money left after deducting all expenses, interest payments, and taxes.

Should the firm fail to turn a profit, but still wish to pay a dividend, it can borrow the money required or tap into its existing cash reserves (if it has any).

Firms have no legal obligation to pay dividends to their shareholders.

Whether they decide to do so is based on a wide range of factors such as:

  • Amount of profit they earn during the year
  • Expectations of their shareholders
  • Amount of cash they have available
  • Current financing needs 
  • Capital expenditure budget
  • Overall business goals
  • Future business opportunities

Each company maintains an overarching dividend policy based on its needs, goals, and circumstances.

You can classify each under one of three categories:

Stable Dividend Policy: Dividends are paid out regularly for a fixed amount, regardless of whether the firm’s earnings rise or fall.

As a result, you can expect predictable payments for the foreseeable future.

Constant Dividend Policy: Dividends are paid as a predetermined percentage of the firm’s earnings.

This means that the amount you receive will fluctuate based on how well the firm performed financially during the year.

Residual Dividend Policy: Dividends are paid out based on the funds remaining after the firm has paid for all capital expenditures.

Thus, you can expect some volatility in dividend size.

In general, mature companies with stable earnings, sustainable business models, and proven track records tend to pay out a significant portion of their earnings as dividends. 

Well-established firms can afford to pay steady dividends as they generate healthy cash flows and are not overly concerned with rapid growth and expansion.

Thus, more money is available for shareholders.

Conversely, fledgling companies that earn little revenue usually pay no dividends.

Their primary focus is on growing their business and capturing market share.

These firms tend to invest their earnings in research and development, marketing, business expansion, acquisitions and more.

As an investor, paying attention to a firm’s dividend policy and track record with dividend payments is crucial.

It paints a picture of how well it may perform in the future.

For example, a high dividend payout may indicate the company is experiencing rapid growth and may increase in value substantially soon. 

Alternatively, a high payout may also signify that the company is no longer pursuing new projects or investing in crucial R&D, which may negatively impact its future profitability.

Definition

Dividend Aristocrats are firms that have paid dividends consistently for at least 25 years and continuously increased the size of their payments.

How Dividends are Paid

In addition to crafting a firm’s dividend policy, the Board of Directors is responsible for approving each dividend payment, determining the payment size, and the payment date.

In Canada, most firms distribute dividends quarterly.

However, some opt for a monthly, semi-annual, or annual payment frequency.

Cash Dividend

The most common way to receive dividends is through cash.

Companies issue cash payments electronically, which they deposit into your brokerage account.

Stock Dividend

A company may choose to pay dividends in additional shares instead of cash.

Usually, companies opt for this payment method to preserve their cash for business investment needs or lack the funds required to pay the dividend.

The issuance of additional shares doesn’t alter the firm’s value, though it does dilute shareholders’ existing equity in the firm.

Dividend Reinvestment Plan (DRIP)

A DRIP is a type of investment plan that enables you to reinvest your cash dividends by purchasing more company shares (even fractional shares).

The transaction is performed automatically on the day of the dividend distribution. 

Since the company conducts the purchase of shares in bulk on your behalf (and that of other shareholders), you can net a sizable discount on commission fees.

Special Dividend

Occasionally, a company may elect to pay shareholders an extra dividend on top of its regularly scheduled dividend payments.

Companies usually issue special dividends when they’re flush with cash and have no immediate plans to reinvest it in the business.

Stock quote with dividend amount open on mobile phone

What is Dividend Yield?

The dividend yield is a widely referenced financial ratio that measures how much a firm pays out in dividends compared to its share price.

Usually, it’s expressed as a percentage and considers the total dividends paid over a year.

The formula for calculating a firm’s dividend yield is as follows:

Annual dividends paid per share / current share price x 100

For example, if the firm’s quarterly dividend is $0.35 and its shares currently trade at $28, the dividend yield is 5% ((0.35 x 4 / $28).

Another way to conceptualize the dividend yield is as a method that measures the return you earn for each dollar that you invest in a particular company.

Did You Know?

While the dividend yield is a popular metric for evaluating the potential return on a stock, an excellent alternative is the dividend payout ratio, which is tied directly to a firm’s cash flow.

Dividend Dates Defined

If you hold investments in dividend-paying shares, it’s important to be aware of the following key dates that surround the distribution of dividends:

Declaration Date

The declaration date is the day the firm’s Board of Directors announces a dividend payment.

They also specify when payment is expected, and the amount paid per share on this date.

Ex-Dividend Date

The ex-dividend date refers to the date the shares trade with no dividend owing to current shareholders.

If you purchase shares on this date, you won’t be entitled to receive the latest declared dividend.

Record Date

The firm reviews its records on the record date to determine who is eligible to receive the upcoming dividend.

Your name must appear on this list by the record date, otherwise you won’t receive payment.

Payment Date

On the payment date, eligible shareholders receive the dividend payment, which the firm deposits into their brokerage account.

Frequently Asked Questions

  • How do you get dividends?
  • Do all stocks pay dividends?

Mark is a freelance writer who specializes in covering personal finance topics related to investing, mortgages, credit cards, and more.

He is passionate about educating people on how the financial markets work and providing tips to help them better manage their money. Mark holds a bachelor’s degree in finance from the Northern Alberta Institute of Technology and has more than a decade of experience as an accountant.

Outside of writing and finance, he enjoys playing poker, going to the gym, composing music, and learning about digital marketing.