In the popular imagination, dividends are sometimes viewed as the preferred financial device of passive or even stodgy investors. There’s even a term for certain equity investments that pay out high dividends, are low volatility in non-cyclical sectors -“widow and orphan stocks,” so called because they’re considered extremely safe investments.
Dividends, however, are an important financial tool in the capital markets for distributing value to shareholders-and some investors find that dividends can help to boost their portfolio growth over time.
Here are a few things you should know about dividends as you think about the role they play in the financial system, and as you consider how they might affect your own portfolio.
What are dividends, and why do companies pay them?
A dividend is a payment made by a company to its shareholders, usually quarterly, from profits or cash reserves. Or to put it more simply, it’s the cut of the earnings you’re entitled to as a part owner of the company. (Profits that are not distributed to shareholders as dividends are known as “retained earnings,” which may be used to finance expansion, acquisitions or other types of investment aimed at growing the company.)
The most common types of dividends are cash dividends, which means investors get a cash payment based on the number of shares they hold, and stock dividends, whereby a company issues investors additional shares of stock.
Businesses have a variety of reasons for paying out dividends. A common dynamic is that as a company grows and matures, its stock value stabilizes, and paying a per-share dividend is a way to “reward” investors who are no longer seeing big increases in share value. Typically it’s the more established firms that pay dividends – smaller, younger companies and start-ups often prefer to reinvest their profits into business expansion to fund their rapid growth.
A dividend payout could also be a way to attract new investors, like a large pension fund that requires a dividend payment from the companies it invests in.
Let’s look at an example. In 2012, Apple Inc. announced the company would begin paying dividendsafter a hiatus of 17 years. After a decade and a half of pouring profits back into the company, Apple CEO Tim Cook explained that the company was ready to return some of those gains to the shareholders:
“We have used some of our cash to make great investments in our business through increased research and development, acquisitions, new retail store openings, strategic prepayments and capital expenditures in our supply chain, and building out our infrastructure. You’ll see more of all of these in the future,” Cook explained. “Even with these investments, we can maintain a war chest for strategic opportunities and have plenty of cash to run our business. So we are going to initiate a dividend and share repurchase program.”
At that time, Apple was paying a dividend of $2.65 per share. Today, Apple’s dividend is 52 cents per share (the dividend was reduced after a stock split in 2014). So if you held 100 shares of Apple stock, you would have received a quarterly dividend of $52 in August, 2015.
Who’s eligible for dividends?
To be eligible for a dividend payment, you need to be a shareholder as of the “ex-dividend” date.
Here’s what that means: when a company’s board of directors decides to pay a dividend, they’ll set a “date of record” for the dividend payment. Two business days before the date of record is designated as the “ex-dividend” date (often shortened to “ex-date”). Anyone who purchases shares of stock after the ex-date is not eligible for the current quarterly dividend payment. (This explainer from the Securities and Exchange Commission offers more detail on how ex-dates work.)
Many investors prefer to reinvest dividends to grow their portfolio.
Historical data show that, over the long run, stocks generally provide a higher return than other investments. Part of that growth comes from dividends-historically, more than a third of long-term total return from equity can be attributed to dividends.
For most investors, particularly those with smaller portfolios, dividend distributions represent a relatively small stream of income. So rather than receive the payments directly, they simply elect to reinvest their dividends into additional shares (or partial shares) of company stock.
Reinvesting dividends can serve to boost your investment returns over time. Even small amounts of reinvested dividends can make a difference. Many companies offer dividend reinvestment plans (DRIPs) that allow you to leverage the power of dividends compounded over time.
The reality is that most of us can’t live off the dividends our portfolios earn, but dividends can be fed back into the portfolio to generate growth over the long term. Talk to your financial professional to find out more about how you can make dividends work for you as part of your investing plan.
Do I have to declare dividend income on my taxes?
Yes. Companies mail 1099-DIV forms to shareholders at the end of the year detailing the dividend distributions each shareholder received, and you’ll need to include the total amount of dividends received on your tax return.
As always, investors should consult with their financial professional in order to strive to build a diversified portfolio.
Other dividend resources:
If you want to dig deeper to see how much “bang for your buck” you get from dividends, you can calculate the “dividend yield,” which expresses the dividend value as a percentage of the share price. Here’s a simple dividend yield calculator to experiment with.
Want to learn more about a company’s dividend payment history? There are numerous searchable online databases that show companies’ dividend history by year-here’s one from NASDAQ and one from the New York Stock Exchange. Or you can run a simple web search on the company name and “dividend history,” which will likely direct you to the company’s investor relations page.