What are Dividends?
Dividends are payments made by a company to the shareholders. This is a way for companies to distribute revenue back to the investors, and one more way to earn a return from investing in a stock. Companies usually pay dividends quarterly and is the dividend amount is a percentage of the stock price.
Dividends however are not guaranteed. Dividends must be approved by the company’s board of directors each time they are paid. There are 3 key dates to remember regarding dividends:
- Declaration Date: date the board of directors announce its intention to pay a dividend
- Ex-Dividend Date: The ex-dividend date is normally two business days before the record date. If you purchase a stock before the ex-dividend date, you will get the dividend.
- Date of Record: date upon which the stockholders of records are entitled to the upcoming dividend payment. It takes 1-2 days for trade to settle. That’s why ex-dividend date is the date you need to purchase in order to be eligible for the next dividend.
- Payment Date: date the dividend will be paid out to the shareholders
Why do Companies Pay Dividends?
Dividends a way to make a company’s stock more attractive since it guarantees more than one method to generate returns for the shareholder. This works well for mature companies who won’t generally see the same growth as new companies but could still be very profitable.
Take bank stocks such as Toronto-Dominion Bank (NYSE:TD) compared to Uber (NYSE: UBER). TD has a low potential for unicorn growth whereas Uber has the potential to become the market leader of public transportation in the future. For TD to remain attractive in the stock market, TD offers quarterly dividends whereas companies such as Uber does not.
When to Buy a Stock to Receive the Dividend?
The short answer is you only need to own the stock for 2 business days before the date of record to be eligible for the next dividend. In most cases, the price will increase the weeks prior to a dividend payout because of the expected demand of people following the same trend.
If you are planning to sell the stock right after the payout, you need to ensure that the drop in price shortly following after the payout does not negate the gains you receive from the dividend.
What Metrics to Look for When Considering Dividend Stocks?
When comparing dividends between the company, you must consider the dividend yield. The dividend yield is the ratio of a company’s annual dividend compared to it’s share price.
What are the Risks to Dividends?
Dividends are not guaranteed: Dividends are not guaranteed. Investors must be 100% clear on the fact that dividends, by definition, are up to the discretion of companies and can stop at any time.
High dividend yield can be an indicated due to a declining stock price: Higher dividend yields aren’t always an attractive investment opportunity, as the high dividend yield can be an indicated due to a declining stock price.
For example, if stock XYZ was originally $50 with a $1.00 annual dividend, its dividend yield would be 2%. If that stock’s share price fell to $20 and the $1.00 dividend payout was maintained, its new yield would be 5%. While this 5% dividend yield may be attractive to some dividend investors, this is a value trap.
If you’re interested in dividend investing, I would recommend also learning about REIT or MLPs. Real Estate Investment Trusts and Master Limited Partnerships are very popular among dividend investors as they tend to offer much higher dividend yields than stocks. These companies tend to offer high dividends since they are required to distribute at least 90% of earnings to shareholders in the form of dividends. These companies do not pay regular income tax on a corporate level, instead the tax burden is passed down to the investor.