How Do Dividends Work?

by Patrick Gleeson, Ph. D., ; Updated May 22, 2018
How Do Dividends Work?

Back in the day when your stock dividend came in the mail, you (or someone older than you!) got a little thrill when pulling out the dividend check. These days, most investors instruct their brokers to reinvest the dividend, so you may not even notice you've received it. Nonetheless, that dividend is an important benefit of your ownership in the company.

What Are Dividend Stocks?

Well, they're stocks that pay dividends, obviously, but dividend stocks are sufficiently different from other stocks that it's worth considering what beyond the dividend makes them different and how the differences benefit you.

The first and possibly the most important thing to know about dividend stocks is that your quarterly dividend is only one of the benefits. A detailed (and, yes, slightly wonky) study based on data originally collected by distinguished economist Kenneth French shows that over the long run and as a class, dividend stocks outperform stocks that don't pay a dividend by a comfortable margin, about 1.48 percent a year.

At first, that might not seem like a lot, but remember that gains in your stock account are effectively compounded. Suppose you bought 100 shares each of two stocks with identical share prices of $220. You invested $22,000 in each company. After 10 years, your non-dividend stock stocks may have gained the long-term stock market average of 10 percent. Using one of several compound interest calculators available online, you determine that their value after 10 years is $59,794. Recalculating with the additional 1.48 percent additional gain, however, the value of the other stock is $69,328, nearly $10,000 more!

Now, this example is only hypothetical, and in reality, each stock might gain more or less than what's proposed. But you get the idea – in the long run, it's highly probable you're going to make more money investing in companies with dividend stocks than in companies that don't declare dividends.

How Do Dividends Work?

When you buy a stock, you're buying a share of the company. In most cases, it's a very small share and so usually you'll buy 100 shares or more.

As the company continues earning money, it distributes some of those profits, usually once each quarter, to the owners. That's you!

The basics of a dividend declaration are pretty simple. The one aspect of dividend distributions that's interesting, and in some certain circumstances important to consider, is that it doesn't matter when you buy the stock, so long as you own it on the qualifying date.

Here's where it can get a little confusing. According to the U.S. Security and Exchange Commission, the date the company declares the dividend is called "the record date," which makes sense – you're on the company records as a shareholder as of that date. But also according to the SEC, stock-exchange rules require you to be on the company books as a shareholder as of the "ex-dividend" date, which is usually set one business day before the record date.

The SEC language isn't crystal clear and the word "usually" in this context isn't entirely reassuring, but what this means, in practice, is that to be certain you're qualified to receive the dividend, you should purchase the stock no later than the day before the "ex-dividend date," which is two days before the record date when the dividend is announced.

In practice, knowing the ex-dividend date before it's announced is less daunting than it at first appears. No crystal ball is required. Various websites keep track of these ex-dividend dates. One such dividend tracking website, listed in the References, even has a countdown clock telling you how many days are left before the ex-dividend date.

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How Is the Dividend Calculated?

Quick answer: It isn't. There's no requirement for a company to pay a dividend at all. If it does, the company’s Board of Directors determines the amount of the dividend. In practice, the board gets a lot of input from C-suite executives, especially the CEO (chief executive officer), the CFO (chief financial officer) and the COO (chief operating officer). But the Board can declare the dividend for whatever amount it decides.

What Companies Pay Dividends?

A majority of S&P 500 companies – more than 80 percent – pay dividends. Dividend.com has a list available online of companies with the highest dividend yields.

A few very large companies, primarily in the tech sector, either don't pay dividends or have delayed paying dividends for several years – Amazon, for instance. The strategy allows more company earnings to be reinvested in the business. In Apple's case, the strategy finally appeared nearly ridiculous at a point where they had more cash on hand than any other company in the world. Apple's execs have since recalibrated and as of 2018, Apple's total dividend payout is the highest in the world.

Are Dividends Taxed?

All dividends are taxed, but so long as dividends are "qualified" they're taxed at the substantially lower capital gains rate that applies to your tax bracket. For a dividend to be qualified, the IRS requires that you own the stock for a minimum of 61 days during the 120-day time period that begins 60 days before the ex-dividend date.

Is a Dividend Good or Bad?

This is one of those nearly unanswerable questions like "Is being left-handed good or bad?" Some say lefties are slightly more intelligent, but there's some reports that purport they die a little sooner. Which would you prefer?

Similarly, dividend-paying corporations enjoy slightly superior long-term price appreciation, which doesn't quite jibe with the fact that companies that pay dividends are investing in their businesses at slightly lower rates. A compromise view, supported by data, is that the stock prices of companies that pay low dividends appreciate fastest of all.

The takeaway here is that dividends are generally good for both you, the investor, and for the company so long as the dividend amount is low enough for the company to retain sufficient earnings to facilitate research, investment and growth.

One Last Thought on Dividends

If you're just getting into stock investing and trading, you might be tempted to buy a stock just in time to qualify for the dividend and then to hold it just long enough to have the profit qualify as a long-term capital gain.

Nope, won't work. What happens to the stock price on the ex-dividend dates in most cases is that it drops by approximately the amount of the dividend, so on the ex-dividend date, you're back to where you started, with a dividend worth X and a share price that's X-amount lower. By the time you can sell the stock and get the long-term capital gain qualification, the stock price may have rebounded, stayed the same or dropped.

About the Author

Patrick Gleeson received a doctorate in 18th century English literature at the University of Washington. He served as a professor of English at the University of Victoria and was head of freshman English at San Francisco State University. Gleeson is the director of technical publications for McClarie Group and manages an investment fund. He is a Registered Investment Advisor.

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