There are two ways that shares of stock in a company can make money for investors. If the price of the stock goes up, shareholders make a profit. Dividends earn money for stockholders either as cash payment of part of the company’s profits to investors or as new shares issued to the stockholder. How dividends are paid out depends on the type of stock and the company’s policies. Preferred stocks have guaranteed fixed-rate dividends. Some preferred stock issues may also earn additional dividends if the company’s earnings are good. Common stocks may or may not pay dividends, and may be in the form of cash or stock dividends. Many investors also choose to enroll in a dividend reinvestment plan (DRIP) that uses any cash dividends to purchase additional shares of stock.
Shares of common stock are equity securities that investors buy to become stockholders (part owners) in a company. For dividends to be paid, the company must first satisfy its other financial obligations, such as paying creditors and guaranteed dividends on preferred shares (see below). In general, dividends on common stock are paid only if the company is earning a profit. The size of the dividend per share is set by the company’s Board of Directors. Some companies pay out a large part of their profits in dividends (utility companies usually have high common stock dividends, for example). However, it’s not unusual for a company that is earning excellent profits to pay low dividends (or none at all) if it is strongly growth-oriented. Instead, the money is retained and reinvested to support growth. When dividends are paid, it’s usually on a quarterly basis and the shareholders get a check much as they would if they were investing in a CD or corporate bond. An alternative that some growth-oriented companies use is the stock dividend. Here, instead of a cash payment, the shareholders receive new shares in proportion to how many shares they already own. The investor can sell the shares for cash or retain them in hopes the stock will grow in value. The company retains the profits and reinvests them.
A preferred stock is a special form of stock that has a guaranteed dividend which must be paid if the company has the money to do so. Preferred stock dividends must be paid before any common stock dividends. The terms of the preferred shares set the dividend amount (rather than the Board of Directors). Most preferred stock dividends are cumulative, meaning that if the company is unable to make a quarterly dividend payment, it must make up the shortfall when business conditions permit and before any common stock dividends can be paid. Some preferred stocks are “participatory,” meaning they can also earn additional dividends over and above the guaranteed amount, depending on the company’s profits.