Understanding Dividends

Understanding Dividends
In the pursuit of capital growth, many investors often overlook the importance of dividends. This, however, can be an extremely myopic strategy. Aside from boosting the total return of an investment over time, dividends can also serve as a financial cushion during a declining or prolonged bear market marked by negative investor sentiment and general economic uncertainty. Dividends can also provide a supplemental source of income which can help pay for daily living expenses.

What Are Dividends And How Do They Work?

A dividend is a distribution of a company's current earnings usually paid in the form of a cash payment to shareholders. It can also be paid in the form of stock or property. Dividends do not have to paid and are declared solely at the discretion of the company's board of directors. The exact percentage of earnings paid out in the form of dividends will vary among companies. The percentage of net income paid out to the shareholders is referred to as the payout ratio. It is calculated by dividing the total dividends paid on the common stock by the net income of the corporation. Dividend paying companies can be found in a broad array of sectors such as food and utilities. The dividend per share is simply the annual amount of cash dividend paid for each share of common stock. The dividend yield can be easily calculated by dividing the annual dividend by the purchase price of the stock. If a stock is selling at $25 share and the annual dividend is $1.00, the dividend yield is 4%. When it comes to dividends, there are four dates to keep in mind:

1. Declaration date: The declaration date refers to the date on which the board of directors meets and announces the amount, date of payment and date of record for the upcoming dividend. This is usually followed by the publication of a press release announcing a declaration of the dividend.

2. Ex-dividend date: A stock is said to be "ex-dividend" because that is the first day that the buyer of the stock does not receive the declared dividend. The stock is being sold without a dividend. The ex-dividend date is 2 business days before the record date. The price of the stock generally tends to drop by the amount of the dividend when it goes "ex-dividend" because new buyers will not receive the dividend. An investor must be a shareholder of record before the ex-dividend date in order to receive the upcoming scheduled dividend.

3. The record date: This is the date on which the company determines who is eligible to receive the dividend or distribution. The dividends can only be paid to shareholders of record.

4. The payment date: The payment date is when the dividends will actually be paid. Most companies pay dividends quarterly. The dividend checks are mailed to all shareholders of record.

Cautionary Notes About Dividends

As with the hunt for greater capital growth, chasing dividend yield without maintaining a balanced investment perspective can prove to be equally disastrous. To avoid any possible pitfalls when looking for dividend-paying stocks, it is helpful to note the following points:

• A dividend payment is an enormous privilege. No company is obligated to pay a dividend. Dividend increases are never a sure thing and should not be expected on the part of investors. Companies can reduce or even eliminate a dividend payment.

• Never buy a stock based purely on its dividend yield. An unusually high dividend can be a warning sign that the company is undergoing financial or business difficulties.

• Thorough investment research is essential in order to select and assemble a portfolio of high quality dividend-paying stocks. One commonly utilized investment approach is fundamental analysis. Fundamental analysis attempts to measure the intrinsic value of a specific stock through detailed research and evaluation of the various determinants of stock value such as the company's balance sheet, earnings, business expectations for the future and dividend prospects. Briefly, fundamental analysis begins by studying and evaluating existing broad-based business and economic trends. It then studies a specific company in the context of the overall economy and its industry by evaluating its business prospects including its strengths and weaknesses, competitors, history, management, product lines and risk, among many other aspects.

• As always, the share price of the stock matters. Buying stock at an overvalued price is a risk that should not be underemphasized. While a 3.5% dividend yield on a stock is alluring, consider how many shares can bought if its current market price is $85 per share.

• Build your portfolio slowly over time to take advantage of market fluctuations.

• Keep current of existing business, economic and pertinent industry news and trends as they affect your stock holdings.

• Never fall in love with a dividend-paying stock.

For informational purposes and not intended as advice. Every attempt is made at accuracy, however, the author does not claim that the content is free factual errors.

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