Dividend Stocks : The Basics

The Pros and Cons of Dividend-Paying Stocks for Muslims ...

You’ve heard of this word before… What exactly are dividends? Dividends are a sum of money paid regularly (typically quarterly) by a company to its shareholders out of its profits (or reserves). In the U.S., most dividends are cash dividends, which are cash payments made on a per-share basis to investors. For instance, if a company pays a dividend of 20 cents per share, an investor with 100 shares would receive $20 in cash. Stock dividends are a percentage increase in the number of shares owned.

Dividends must be approved by the shareholders through their voting rights. Although cash dividends are the most common, dividends can also be issued as shares of stock or other property. Along with companies, various mutual funds and exchange-traded funds (ETF) also pay dividends.

A dividend is a token reward paid to the shareholders for their investment in a company’s equity, and it usually originates from the company’s net profits. While the major portion of the profits is kept within the company as retained earnings- which represent the money to be used for the company’s ongoing and future business activities–the remainder can be allocated to the shareholders as a dividend. At times, companies may still make dividend payments even when they don’t make suitable profits. They may do so to maintain their established track record of making regular dividend payments.

How Dividends Affect Stock Prices

The board of directors can choose to issue dividends over various time frames and with different payout rates. Dividends can be paid at a scheduled frequency, such as monthly, quarterly or annually. For example, Walmart Inc. (WMT) and Unilever PLC ADR (UL) make regular quarterly dividend payments.

Important Dividend Dates

So when do I get paid? Dividend payments follow a chronological order of events and the associated dates are important to determine the shareholders who qualify for receiving the dividend payment.

  • Announcement Date: Dividends are announced by company management on the announcement date, and must be approved by the shareholders before they can be paid.
  • Ex-Dividend Date: The date on which the dividend eligibility expires is called the ex-dividend date or simply the ex-date. For instance, if a stock has an ex-date of Monday, May 5, then shareholders who buy the stock on or after that day will NOT qualify to get the dividend as they are buying it on or after the dividend expiry date. Shareholders who own the stock one business day prior to the ex-date – that is on Friday, May 2, or earlier – will receive the dividend.
  • Record Date: The record date is the cut-off date, established by the company in order to determine which shareholders are eligible to receive a dividend or distribution.
  • Payment Date: The company issues the payment of the dividend on the payment date, which is when the money gets credited to investors’ accounts.
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Why Companies Pay Dividends

Because dividends are typically a sign of financial health, a company may offer them to attract investors and drive the share price up. Generally, companies pay dividends when money is left over after covering operating expenses and business reinvestment. That’s why mature companies, which require less capital reinvestment, are more likely to pay a dividend.

Why do some companies not pay dividends? A young, rapidly growing company, on the other hand, often needs to reinvest all its capital to fuel growth and can’t afford to pay a dividend. Some investors prefer this because dividends are taxed at ordinary income rates. If a non-dividend-paying company reinvests its capital and grows, investors benefit from the rising stock price, a gain that isn’t taxed until they sell. A mature company may also skip paying a dividend in favor of reinvestment or to cover costs. This can be a bad omen for investors, particularly if the company is under financial strain or anticipates future earnings to slow.

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Impact of Dividends on Share Price

Since dividends are irreversible, their payments lead to money going out of the company’s books and accounts of the business forever. Therefore, dividend payments impact share price – it rises on the announcement approximately by the amount of the dividend declared and then declines by a similar amount at the opening session of the ex-dividend date.

For example, a company that is trading at $60 per share declares a $2 dividend on the announcement date. As soon as the news becomes public, the share price will shoot up by around $2 and hit $62. Say the stock trades at $63 one business day prior to the ex-dividend date. On the ex-dividend date, it will come down by a similar $2 and will start trading at $61 at the start of the trading session on the ex-dividend date, because anyone buying on the ex-dividend date will not receive the dividend.

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Different classes of stocks have different priorities when it comes to dividend payments. Preferred stocks have priority claims on a company’s income. A company must pay dividends on its preferred shares before distributing income to common share shareholders.

Stock or scrip dividends are those paid out in the form of additional shares of the issuing corporation, or another corporation (such as its subsidiary corporation). They are usually issued in proportion to shares owned (for example, for every 100 shares of stock owned, a 5% stock dividend will yield 5 extra shares).

Nothing tangible will be gained if the stock is split because the total number of shares increases, lowering the price of each share, without changing the market capitalization, or total value, of the shares held.

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Stock dividend distributions do not affect the market capitalization of a company. Stock dividends are not includable in the gross income of the shareholder for US income tax purposes. Because the shares are issued for proceeds equal to the pre-existing market price of the shares; there is no negative dilution in the amount recoverable.

Property dividends or dividends in specie ( Latin for ” in kind”) are those paid out in the form of assets from the issuing corporation or another corporation, such as a subsidiary corporation. They are relatively rare and most frequently are securities of other companies owned by the issuer, however, they can take other forms, such as products and services.

Interim dividends are dividend payments made before a company’s Annual General Meeting (AGM) and final financial statements. This declared dividend usually accompanies the company’s interim financial statements.

Other dividends can be used in structured finance. Financial assets with known market value can be distributed as dividends; warrants are sometimes distributed in this way. For large companies with subsidiaries, dividends can take the form of shares in a subsidiary company. A common technique for “spinning off” a company from its parent is to distribute shares in the new company to the old company’s shareholders. The new shares can then be traded independently.

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How to Find the Best Dividend Stocks

A common starting point for choosing these investments is the dividend yield, or the annual dividend per share divided by the share price. The yield measures how much income investors receive for each dollar invested in the stock. For example, a stock trading at $100 per share and paying a $3 dividend would have a 3% dividend yield, giving you 3 cents in income for each dollar you invest at the $100 share price.

General Electric Co. in 2017 is a perfect example: “At its 52-week high, (GE’s) stock had a yield of about 3%, and at its 52-week low, it had a yield of about 3%,” Davis says.

An investor who looked only at GE’s yield would think nothing had changed when in fact the stock was down more than 40%, producing not only a loss of income to the shareholder, but also a loss in principal.

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Having a combination of growth in our principal and growth in our income is known asa the principal of total return, or the increase in share price and paid dividends. To find companies that are good total return prospects, investors should consider what enables a company’s business to grow so that its dividend will, too.

This may sound daunting, but the process isn’t that different from asking a bank for a mortgage. The same way a lender looks at your bank statements and pay stubs to determine how much cash is coming in and if you can afford to pay your mortgage, investors can read a company’s financial statements to determine how it funds the dividend and if it can afford to continue paying it.

If a company isn’t funding (its dividend) through cash flow and operations, (it’s) either depleting assets or borrowing money to pay it, and normally that’s not sustainable. Their dividends will essentially be short lived. 

Dividends are paid from a company’s free cash flow, calculated as the operating cash flow minus capital expenditures.

Companies with a demonstrated ability to generate free cash and return that cash to shareholders over time will be in a better position to deliver superior total return however the wind blows.

“The best thing you can have as far as a strong dividend-paying stock is a healthy company.

A healthy company is one with stable, growing cash flow and earnings. To view a company’s quarterly and annual earnings and its free cash flow, pull up the company’s description page by searching the name or ticker on the U.S. News website and look under Company Vitals.

Use the Payout Ratio to Find Sustainable Dividends

Also available under Company Vitals is the dividend payout ratio, which calculates the proportion of the firm’s earnings paid as dividends.

The payout ratio is another indicator of how sustainable a firm’s dividend policy is. A company that pays out too much of its earnings can’t expect to sustain both its dividend and its growth.

Research by Santa Barbara Asset Management found that the companies with the highest payout ratios had the worst total return over the past two decades. Meanwhile, firms in the middle of the payout pack showed the greatest total return.

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In today’s environment, dividend yields ranging between 1% and 3%, coupled with payout ratios in the 10% to 40% range should have a greater likelihood of not only surviving in the near term without cuts, but potentially thriving in the future with dividend growth longer term.

This modest payout ratio works to an investor’s favor because the company is then able to reinvest the rest of its earnings. If that reinvestment is successful and the business grows, then the following year, when the company again pays a dividend, the dividend is larger because the earnings for the year are higher.

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Look for Dividend Growth

A sustainable dividend with growth potential is like hitting the jackpot. If you get both you can create an ever-increasing income stream from the stock.

To find companies with growing dividends, there are two things that you should look for. First, the firm must have doubled its dividend over the past decade. This translates to about an average 7.18% annual dividend growth rate, putting it well above the average annual inflation rate of 3.8%.

Second, for consistent annual dividend increases, the firm must have increased its dividend eight out of 10 years without reducing it the other two. What you want (to determine) is not what they’ve done in the past but what they will do in the future.

You’ll need to determine how confident you are that the company can attain the growth you’d like to see. The future annual dividend growth should be in the high single digits or even 10%.

The best growth companies are typically leaders in their industries or market niches. These companies have end markets with good growth prospects and a history of success but often aren’t growing the fastest.

Beware of Cyclical Sectors and Companies With Too Much Debt

Avoid commodity-linked companies or those in sectors with cyclical profits and cash flow. They may not be able to continue paying a dividend in the down cycle for that particular commodity or sector.

You should also steer clear of companies with too much debt because that means more of its cash outflows are controlled by bondholders, whose interest payments are mandatory, rather than shareholders, whose dividends are optional. In hard times, these firms could cut their dividends to avoid defaulting on bond payments.

Of course, any company can experience a setback, and diversification is an investor’s best hedging strategy. Experts recommend diversifying dividend income across companies and market sectors.

How Much to Invest in Dividend Stocks?

Remember, dividend stocks are not bonds, which guarantee the return of your principal. Like any stock, dividend stocks are subject to market and company-specific risks.

In addition, dividend stocks face interest rate risk. When interest rates rise, investors may flee dividend stocks for the guaranteed income of bonds, prompting dividend stock prices to fall.

At present, companies are experiencing unprecedented declines in revenues and profits. This will negatively impact many companies’ shares, including the dividend payers. Financial experts have suggested that it may take up to five years for the economy to return to normal – meaning some companies might never bounce back from the current economic downturn.

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Investors seeking shelter during the bear market storm won’t find a perfect solution to handle volatile financial asset prices in dividend stocks. Still, investing in dividend stocks during a bear market can be a successful strategy for long-term investors with cash on the sidelines.

Overall dividends can be a very lucrative investment. It has the potential to pay you over a long period of time and act as a very good stream of income provided that the stocks invested in are doing well. As 2020 has shown us all, many things are unpredictable.

For successful dividend stock investing, choose high-quality companies, don’t chase dividend yields and consider investing in a diversified dividend aristocrat fund like the SPDR S&P Dividend ETF (SDY). By choosing a fund over individual stocks, you’ll spread out the risk of picking the wrong stock.

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