Dividends: How do the "tax-free" income shareholders prefer work?

Dividends are the regular payment investors receive for owning a stock of a company. Not all stocks offer dividends.

If you plan to enter the stock market, you might be looking at many factors, including dividends. Dividends are the tax-free income shareholders prefer, and there are reasons for this. These reasons might also affect the investment decision you are going to make. Some people dismiss dividend stocks as stocks for retirees or retirees' investments, but this is not entirely true because this kind of stock is common in investors' portfolios.

Investors include dividend stocks on their portfolios because of a variety of reasons. These reasons do not depend on the investor's age or financial situation but solely on dividend benefits. Dividend stocks can provide another income aside from selling the stock that is appreciated, it is tax-free for most countries, and most importantly, it has a compounding characteristic. These three are the primary reasons why investors include dividend stocks on their portfolios but the latter stands above the two. Compounding is the most alluring reason because it results in a "wealth snowball," meaning if you reinvested your dividends, you will own more shares, and more shares equates to more dividends.

However, not all stocks offer dividends. When you invest in a company, that company could either give you dividends or not. So, the decision of whether to buy stocks on a company that offers dividends lies on you alone. If you are interested in including dividends in your portfolio, you might want to search for stocks that offer it.

What is a dividend?

Dividends are the profit received by investors who own stocks of a company. It is the share of profit and retained earnings that companies award to their shareholders. When a company produces profit and has sustained retained earnings, it can opt to reinvest it to the business or pay it to shareholders as dividends.

Dividends offer the advantage of rewarding the stockholders without affecting the overall cash balance of the company. But this might dilute the earning per share. Distribution or payment of dividends is made in fractions.

How do dividends work?

The value of a dividend is calculated per share and must be distributed equally to all owners of the same class (common, preferred, etc.). For instance, if a company issues a dividend of 5%, then the company will issue a 0.05 share for each share an investor holds. This means that a shareholder who owns 100 shares will receive an additional five shares. When divided by the price of a share, the dividend per share will result in dividend yield.

The payment of dividends needs the approval of the Board of Directors. Upon approval, it would be declared and afterward paid on a certain date called the payable date.

The process

1.      The company generated profit and has sustained retained earnings

2.      The management decided to give some excess profit to investors

3.      The board approves the planned dividends

4.      The company declares the dividends (payment date, record date, value per share, etc.)

5.      The dividends are given to shareholders

Types of Dividends

There are different types of dividends that companies could choose in paying their shareholders. The type of dividend that a company would give is not arbitrary; it could be based on various reasons like preservation of cash, inadequate cash reserves, etc.

Companies could pay their shareholders through the following:

1. Cash Dividends. The most common form of a dividend. Companies pay the investors in cash by directly depositing it in the investors' brokerage account.

2. Stock Dividends. This is another common form of dividends where instead of cash, companies pay shareholders with additional shares. This type of dividend is done to preserve the company's cash or lack of cash reserves.

3. Preferred Dividends. This type of dividend pays more than the usual dividends. This is a payment issued to investors who hold preferred stocks. Preferred stock is a kind of stock that functions like more of a bond than a stock. It is usually paid quarterly, and unlike those dividends in the common stocks, the dividends that preferred stockholders receive are fixed.

4. Special Dividends. A type of dividend that does not recur regularly. These dividends are given to all investors who hold company stock. This is an "occasional" dividend as companies distribute dividends in this form only when they have an accumulated profit from several years and have no immediate need for it.

5. Dividend reinvestment programs (DRIPs). DRIP is a plan that companies make available to allow investors to automatically reinvest the received dividends back to the company. Dividend reinvestment plans usually offer a discount on the price of each share. It is also commission-free most of the time. There are three types of Dividend reinvestment plans: 1) Company-operated DRIP; 2) Third-party operated DRIP; and 3) Broker-operated DRIP.

Why are dividend stocks parts of an investor's portfolio?

Many investors include dividend stocks in their portfolios for a variety of reasons. These reasons are independent of age and financial situation.

1. Dividends are another source of income. Though some dividends are occasional, others pay regularly.

2. Retirees can set up a dividend payment schedule for each month since some dividends are paid at different times.

3. Young investors can use their dividends for reinvestment, starting a "snowball effect" or compounding.

4. Dividend stocks enjoy a higher yield than bonds, especially when interests are low while offering the same potential for appreciation at the same time.

Why do some companies pay dividends, and why others don't?

A dividend could be considered as an indicator of a company's financial health. Issuing and paying dividends have been seen as a practice or strategy to attract investors or drive the price of shares up. Companies often pay dividends when there is leftover money even after funding the company's operation and reinvestments. These are the reasons why mature companies that require less capital reinvestment manages to pay for dividends.

On the other hand, a new company that is just starting to grow does not have enough to spare for dividends. Young companies need to reinvest their capital to fuel their growth and expansion. But not paying dividends is not only typical for young companies; it is also often seen to mature ones. When mature companies suspend, skip, or cut their dividends, then investors should be wary. Companies that issue dividends before but then suddenly suspend or cut their payment can be undergoing a financial strain; it could also be because of anticipated slower future earnings.

Dividend Dates

Investors have some important dates to remember if they choose to invest in dividend stocks. These dates are the following:

1. Announcement or Declaration Date. The date when the company management announces dividends. This must be approved by the shareholders before they receive their payment.

2. Ex-dividend Date. This is one of the most critical dates an investor should remember as it has a more significant implication on the portfolio. This date determines the expiration of dividend eligibility. For instance, if a stock has an ex-dividend date of September 18, then all the shareholders that bought stocks on that day or the days after it is not eligible to receive dividends since the dividend eligibility has already expired by the time of the purchase. On the other hand, shareholders who bought stocks on the days before the ex-date are entitled to dividends.

3. Record Date. This is when the management looks at the shareholder records to ascertain who is eligible for payment.

4. Payment Date. This date pertains to the date when a company issues the payment for dividends.

Evaluating Dividend

Comparing and choosing what dividend stocks to buy might come as a challenging activity, but some ways could make this easier. There are different ways and methods that investors could utilize to assess and compare the dividends of other companies.

1. Dividend per Share (DPS). One of the ways that investors could use to compare company dividends is through DPS.  Some companies can increase their dividends every year, and the stocks of these companies are sought by investors. DPS shows the number of dividends that a company issued for each stock in a given period. By looking at the DPS, investors can ascertain which company is growing or was able to increase its dividends over time.

2. Dividend Yield. The dividend yield is the measure of a company's dividend divided by the stock price at a given period. This is commonly posted on financial websites or online broker platforms. This measurement even the field between large and small companies, thus providing a more profound and accurate comparison. For example, the dividend yield between a $20 stock that pays $0.20 per quarter ($0.80 per share annually) and a $200 that pays $2 quarterly ($8 per year) is both 4%.

3. Dividend Payout Ratio. Another way of assessing dividend stocks is through the payout ratio or the chunk of its income allocated for dividend payments. Suppose the company uses 100% or more of its income to pay dividends. In that case, the company may be in trouble because there wouldn't be enough to cover the dividends if the company experienced a slump and the earnings dip. Thus, it is good to look for ratios that stand at 80% or below.