Stocks can provide an individual with two returns on their investment. The stock's price can increase over time, and selling shares results in a capital gain. Companies can also pay shareholders dividends, which are usually received periodically throughout the year.
In this article, we're going to cover the topic of stock dividends. As part of that discussion, we'll explain about why some companies pay dividends, and why some investors value them. Next, we'll talk about the dividend payment process, including an explanation of the terms ex-dividend and date of record. We'll finish up with a brief overview of related topics such as the calculation of dividend yield.
When a company generates profits, they have two basic options. They can use the money to purchase additional assets, with the hope of returning even greater profits to shareholders. This tactic creates additional shareholder value as long as the return on these new investments is sufficiently high to satisfy investors.
When a company generates profits, and does not pay dividends, they are essentially telling investors:
I'm going to take your money and reinvest it on your behalf back into my company. I believe I can achieve a higher rate of return than you.
Back in 2011, Apple Computer was a good example of a company that generated a great deal of profits per share, but did not pay dividends. Shareholders like this arrangement because Apple was correct. They used those profits to generate even more earnings for shareholders. The price per share of stock rises, and shareholders have the option of selling their stock and realizing a capital gain.
Companies can also return profits to shareholders in the form of dividends. Typically, companies will keep some of the money to purchase additional assets, and return a portion to shareholders. When a company generates profits and pays a dividend, they are essentially telling investors:
I'm going to take some of your money and reinvest it back into my company. I don't have enough projects that will provide you with an adequate return, so I'm giving some of the money back in the form of a dividend, allowing you to invest elsewhere.
Electric and Gas utilities are usually considered dividend paying stocks. In the United States, utilities are assigned a franchise territory, which defines their geographic service area. In most parts of the country, the electric and gas infrastructure is well-developed. Without the opportunity to expand their networks, only a portion of the profits generated are needed to replace aging equipment. Those excess profits are returned to investors as stock dividends.
In the same way that some investors value capital gains, others value dividends. A steady stream of dividends can be used as a source of supplemental income. This is one of the reasons utility stocks are popular with retirees.
Now that we understand why companies pay dividends, and why some investors value them, it's time to talk about the payout process. Investors purchasing a stock for its dividend need to understand how the process works, or they might not receive a payment during the next cycle.
From start to finish, the dividend payment cycle involves four dates:
Let's take a closer look at the above process using an example.
On December 11, 2020, Company XYZ declares a $1.00 dividend to be paid on February 5, 2021 to shareholders of record on January 11, 2021. Since January 11th falls on a Monday, the ex-dividend date is Thursday, January 7, 2021. In this example, anyone purchasing a share of stock on, or after, January 7, 2021 would not be entitled to the payment of the $1.00 dividend on February 5, 2021.
The above example illustrates the importance of knowing the ex-dividend date. If the stock pays a relatively high dividend, then its price per share will be affected by the payout. In the above example, the stock's market price will reflect the fact it is worth exactly $1.00 less.
That is to say, on the day before the ex-dividend date, the shareholder of record is entitled to a $1.00 per share of stock held. Once the stock goes ex-dividend, this is no longer true. A stock that is trading "ex" dividend will be quoted with an "x" next to the ticker symbol.
Now that we've explained the concept and process, let's talk about a way to identify stocks that pay relatively high dividends. If an investor is looking to screen stocks for income, they'll want to use the dividend yield metric.
The dividend yield, also known as the dividend to price ratio, provides investors with the opportunity to quickly identify stocks with large payouts relative to their price per share. The calculation of dividend yield is as follows:
Dividend Yield (%) = (Dividend per Share / Price per Share) x 100
One of the more popular investment strategies involving dividend yield is the Dogs of the Dow. Popularized by Michael B. O'Higgins back in 1991, the strategy involves purchasing shares of the ten Dow Jones Industrial Average stocks with the highest dividend yield. Since the companies in the Dow are highly-regarded, blue chip stocks, the technique claimed to provide above average returns to the investor.
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