6 Keys to Understanding How Dividends Work

In this article, I present 6 keys to understanding how dividends work.

Welcome to the first part of my Dividend Investing series in which I explain everything you need to know about dividend investing.

In this introductory article, I present the basics:

  • What is a dividend?
  • The dividend yield
  • How do you get paid?
  • The dividend payout ratio
  • The beauty of dividend growth
  • The pain of dividend cuts

1 – What is a Dividend?

A company can use its profits in three ways:

  • Investments for long term growth
  • Retain earnings as cash to strengthen its financial position
  • Pay dividends to shareholders, to reward them for their investment

The dividend is the “part of the profit of a company that is paid to the people who own shares in it” . Indeed, one of the major perks of owning the stock of a publicly traded company grants is the fact that you gain the right to receive a share of its profits.

While most companies make profits, not all pay dividends. Generally speaking, mature, well established businesses pay out dividends while companies who are still growing prefer to retain earnings in order to invest.

To find out if a company pays a dividend, go to yahoo.com and search for the company you’re interested in, like Apple for example.

On the company profile page, look at the “Forward Dividend & Yield” section: the number that appears there is the company’s annual dividend per share.

If this sections is empty, that means the company does not pay a dividend. For example, Amazon does not pay a dividend, so this section displays N/A.

Did you notice the percentage in parentheses next to the dividend per share? This number is the dividend yield.

2 – The Dividend Yield

The Dividend Yield is the percentage of dividend you are receiving relative to the stock price. Imagine this as the interest you are receiving on your investment.

For example, Apple’s Dividend Yield is 0.65%. This means that buying the stock for the current price will yield 0.65% per year.

AT&T, one of the most popular dividend stocks in the world, pays a $2.08 dividend per share, which equates to a 7% dividend yield.

As you can see, different stocks have different dividend yields.

Most novice investors assume that a higher dividend yield equates to a better investment. This is simply not true.

Sometimes, dividend yields are high because the stock price is falling. This usually happens when investors sell their stock due to the company’s declining fundamentals.

If you ignore the fundamentals and buy the stock for its high yield, you risk buying shares of a declining business. The company could experience severe financial difficulties and even go bankrupt. Thus, chances are the dividend will be greatly reduced or eliminated and you’ll be left holding a large amount of worthless stock. This is known as a yield trap.

Thus, as a general rule, solid businesses pay out dividend yields of 1-4%.

Of course, every rule has exceptions. Some companies, such as Real Estate Investment Trusts (REITs), Master Limited Partnerships (MPLs) and Business Development Companies (BDCs) pay out higher than average dividends for legal reasons. However, their dividends are also taxed at a higher rate. Also, these companies are sometimes forced to reduce their dividends if they need liquidity.

In sum, the dividend yield is often proportional to the risk of the dividend being reduced or eliminated. Stock market investing requires constant risk-reward calculation to determine whether an investment corresponds to your investor profile.

Now that you know what dividends are and how much you can earn, you may wonder: how do dividends get paid?

3 – How Do You Get Paid?

Companies usually pay their dividend four times a year. To know the quarterly dividend you’ll receive, go to the yahoo homepage and divide the Forward Dividend by four. However, some companies choose to pay them on a yearly, twice yearly or even on a monthly basis. The payment frequency is determined by the company’s management and rarely changes.

How do I know when a payment is scheduled?

A company will declare the dividend payment date upon release of their quarterly financial reports. However, you must meet certain conditions to benefit from the payment.

First, you need to own the stock before a very specific date well in advance of the actual payment. This is known as the ex dividend date.

Second, you must still own the stock by the date of record. This is the day that the company records which shareholders own its stock and are eligible for payment. This is usually the day after the ex dividend date.

Thus, you must buy the company’s stock at the latest one day before the ex-dividend to be eligible for the payment.

For example, on December 11th, AT&T declared a $0.52 dividend per share payable on February 1st for shareholders of record Jan. 11th, with an ex-dividend date of January 8th. Thus, to get paid on February 1st, you need to buy the stock at latest on January 7th and still be holding it on January 11th.

6 Keys to Understanding How Dividends Work

How do I know how much I’ll receive in dividends?

To know how much you’ll receive, look at the dividend per share. In the case of AT&T, the declared dividend is $0.52 per share. If you own 100 shares, you’ll $52.

How are dividends taxed?

In most countries, dividends are taxed either as regular income or as capital gains. Most countries allow you to invest in tax-free accounts where your dividends are either not taxed or taxed at a lower rate than normal.

These days, most brokers handle the tax process for you. They simply take the government’s cut from your dividend payment, so you don’t really need to do anything.

In any case, research your country’s dividend taxation policy to make sure you’re to complying with the tax code. The last thing you want is the tax man knocking on your door demanding several years’ worth of unpaid dividend taxes.

Can I buy a stock before the ex dividend date and sell it the next day?

This is called a dividend capture strategy.

In theory, you could buy a stock before the ex dividend date, and sell the stock immediately after the record date. Unfortunately, this is very difficult to pull off.

The problem is that stocks decline in value by the dividend amount immediately following the ex-dividend date. So if a company is paying a dividend of $1 per share, the stock price will fall by $1, so selling your stock would cancel the gains you made of receiving the dividend.

Experienced traders can sometimes pull this off, but novice investors usually end up losing money doing this.

As an investor, knowing that a company pays a dividend is not sufficient. You must also ask yourself: how much of its profits is the company paying out as dividends?

4 – The Dividend Payout Ratio

The dividend payout ratio is the ratio of the companies’ net income that is paid out as dividends. Simply put, this ratio is the percentage of earnings paid as dividends to shareholders. The payout ratio is very useful to measure how much money the company is paying out to shareholders and how much it reinvests, pays off debt and retains in cash.

For example, Apple has a dividend payout ratio of roughy 20% and AT&T has a payout ratio of 65%. This leaves Apple with 80% of its profits for investing, paying off debts and saving, and AT&T with 35% of its profits for such purposes.

Mature businesses with large economic moats tend have higher payout ratios because they don’t need to invest a lot of money to remain market leaders. Also, they have such massive profits that investing just 20% of them is enough to get by and fund their growth.

On the other hand, younger companies will have lower payout ratios because they need lots of capital to invest in growth. They prefer to invest in order to have an edge over their competitors. They can think about increasing their payout ratios when they become big enough.

What is the ideal payout ratio?

There is no ideal payout ratio applicable to every company. However, there are some considerations which help us form guidelines to live by.

First, as already mentioned, business’ maturity is key. Is the company a well established market leader who has a significant economic moat? Or is it an up and coming growth company in a highly competitive industry? The first can afford to pay a majority of its earnings as dividends (in some cases, up to 80%) . Unfortunately, the second cannot (typically pays less than 20% payout ratio).

Second, the company’s legal structure. For example, REITS, MLPs and BDCs sometimes pay up to 90% of earnings (or more) as dividends:

  • REITs and BDCs are legally required to pay 90% of their taxable income as dividends to avoid paying corporate taxes
  • MLPs are ‘pass-through’ entities that don’t pay corporate taxes because they pass through their cash flow and tax obligations to unit holders.

Third, the sector is crucial. Certain sectors require constant investments for innovation, growth and developing competitive advantages. For example, the technology sector is notorious for the very small dividend yields its companies pay out to sharehlders. However, it’s a rapidly growing sector so the lack of dividends is made up for by rapid stock price appreciation.

Other sectors require much less investments which allows those companies to pay out more generous dividends to shareholders. On the flip side, these companies are in sectors where growth is minimal, so share price appreciation is inferior. For example, the tobacco industry is well known for its generous shareholder policies.

Why do some companies have payout ratios above 100%?

A company with a payout ratio above 100% is paying out more dividends than it generates in profit.

For example, if company A reports $100 million in net income and pays out $150 million in dividends, it is paying out $50 million more than it earned. Thus, its dividend payout ratio is 150%.

How is this possible?

Some companies have payout ratios above 100% for a couple of reasons:

i) The company reports lower than anticipated earnings and honors its scheduled dividend by using cash from its reserves

ii) The company has a long history of paying dividends – or a strong commitment to honoring its dividend payment to shareholders – and is borrowing funds to pay the dividend when financial results are consistently poor.

Is a payout ratio above 100% sustainable?

In the short term, yes it is. A company can indeed pay out more in dividends than it earned so long as it has sufficient cash on hand or access to credit.

In the long term, it is clearly not sustainable. No company can pay out more in dividends than it earns forever; it’s simple mathematics.

If the company’s financial situation doesn’t justify paying out the current dividend, management will make the tough but necessary decision to reduce it to a more reasonable level. If the company is experiencing severe difficulties, or is on the brink of bankruptcy, management will eliminate the dividend and use that capital to pay off its debts or invest in growth.

It is your responsibility as an investor to scrutinize a company’s dividend policy to make sure it is sustainable long term.

5 – The Beauty of Dividend Growth

Always remind yourself that a dividend payment comes out of a company’s profits.

As you know, well managed companies grow their profits over time. When they do, management can increase the dividend payment to shareholders.

Shareholders usually love dividend increases because they increase their yield on cost (YOC).

What is yield on cost (YOC)?

YOC measures the dividend yield by dividing the current dividend by the average price paid for the stock. If you purchased a $100 stock with a $1 dividend per share two years ago, the original dividend yield was 1%. If the stock price is now $150 and its dividend per share $1.50, it appears the dividend yield is still 1%. However, you purchased the stock for $100, not $150. Thus, you need to divide $1.50 by $100, which means your YOC is 1.5%.

Yield on cost is an important metric because it allows you to measure the growth of your dividend income over time.

You can also use the average annual growth of the dividend to make a future projection of your yield on cost. For example, if you buy a stock for $100 today and the current dividend yield is 1%, you may think you’re getting a raw deal. But if you see that the company a) has a modest payout ratio of 25% and b) is raising its dividend by 25% every year, you’ll realize that the stock has tremendous potential. After 5 years, your yield on cost will be 3%; in 10 years, your yield on cost will be 9%.

Suddenly, the seemingly poor purchase becomes much more enticing.

What are the drawbacks of dividend increases?

In some cases, investors may view dividend increases in a negative light. Indeed, increasing the dividend means that the company has less funds for other uses.

Sometimes, a company’s management will implement an aggressive dividend policy at the expense of much needed investments or debt repayment, which can really hurt a company’s long term prospects.

Long term investors are concerned about the company’s ability to pay dividends consistently. They are not interested in sacrificing the company’s long term future for a short term dividend increase.

6 – The Pain of Dividend Cuts

Remember: dividends are paid out of a company’s earnings or cash reserves.

As such, they are by no means guaranteed for perpetuity. In fact, companies reduce and even eliminate dividends all the time. This is usually the case during times of economic hardship.

During the 2020 Covid-19 pandemic, some very well known, and typically reliable companies decided to eliminated their dividends: Wells Fargo, Disney Corporation, Carnival Cruise Lines, Airbus, HSBC, Goodyear, and Rolls Royce, among others, all slashed their dividends to zero.

Obviously, high-yield companies such as REITs are among the first to drastically reduce or eliminate dividends during such times.

Thus, investors should seek proper diversification to ensure that a dividend increase does not destroy their investment objectives. This is particularly true for retirees who are investing in dividends to provide supplementary income. If you are over-investing in a certain stock due to its high yield, and that company cuts its dividend, you are left in a very difficult situation.

In the next article of this series, we will see how to build a dividend portfolio and explore strategies to maximise your returns without taking on too much risk.

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DISCLAIMER: This article is the fruit of my personal research and should not be viewed as financial advice. I enjoy analyzing stocks and providing investment ideas but I highly encourage you to conduct your own research before investing in any asset. NEVER invest without having done proper due diligence and NEVER invest out of the Fear Of Missing Out (FOMO). Also, NEVER invest because some internet message boards are hyping up a high-flying stock. As a rule of thumb, the number of rockets included in a tweet are inversely proportional to the quality of the advice given.

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