In the mid-20th century, almost all publicly traded companies paid dividends to their shareholders. A dividend is a payment to shareholders made from the company’s retained earnings, usually paid every quarter. Shareholders had a variety of options for receiving the payment—from a scrip dividend (a promissory note to allow future purchase of additional shares), to a straight cash payment, to a stock dividend distribution (which pays the dividend amount in the form of additional shares).

Why would a company do this? Success means more cash, and sharing the rewards with shareholders, who in actuality are part owners of the company, makes the stock more attractive. However, in the last several decades, dividend-paying companies fell out of favor as younger investors were attracted to companies that chose to reinvest earned capital into growing their businesses. Dividends are coming back into fashion, as evidenced by the recent decision of one of the most profitable companies in the world—U.S.-based Apple Inc.—to begin paying a dividend.

A dividend is a payment that is credited or debited into a shareholder’s trading account (depending on if a shareholder is buying or selling). A company generally emits dividend payments to attract more investors.

How Dividend Payments Work

The timing of when you purchase shares determines your eligibility to receive the dividend payment. There are several date designations you should know. The first is the Declaration Date. Using Apple as an example, management will make an announcement that includes the dividend-per-share amount and the qualifying dates. The Book Closure or Record Date is the calendar date on which all Apple registered shareholders are eligible for the dividend, to be distributed on the Payment Date. Trades officially take three days to close, so if you buy Apple shares on the record date, you will not receive the dividend. The cut-off date is called the Ex-Dividend Date, two days before the record date. To be eligible for the dividend, you would have to buy Apple shares before the ex-dividend date. The last date for eligibility is called the In-Dividend Date, one day before the ex-dividend date and three days before the record date.

The Declaration Date is when the company announces the dividend-per-share amount and the qualifying dates. The Book Closure date is when shareholders are eligible for the dividend payment. The Ex-Dividend Date is the date in which the dividend payment is released.

The Lure of the Dividend Yield

In theory, dividend-paying stocks offer an attractive alternative to traditional fixed-income investments such as bank certificates of deposits, government securities, and bonds. This is true now more than ever as we find ourselves in a period of historically low interest rates. Unfortunately, many novice investors limit their comparison of a dividend-paying stock to a fixed-income investment to the Dividend Yield you find listed on financial websites. It doesn’t take a professional financial analyst to figure out that the dividend yield of 7% from XYZ Company is far superior to the paltry 2% or less on bank deposits and government securities.

What’s wrong with investing in a stock based solely on its high yield? Yield is a percentage expressing the relationship between what you pay for the stock per share and the dividends you receive per share. The calculation divides dividends per share by the share price. A company with a share price of £100 and a dividend per share of £5.00 has a yield of 5%. Again, it doesn’t take a mathematics’ major to see that in the event that the share price falls, the yield rises even though the actual dividend remains the same. In our example, if the price per share drops to £50 and the dividend payment remains the same, the yield increases to 10%.

Traders shouldn’t base their investing decisions solely on high dividend yields—most of the time, when a share price falls, the yield rises, consequently maintaining the same previous price for the dividend.

Dividend-Paying Stocks – the Upside

With a five-year term on a bank deposit, a five-year government security, or a corporate bond, you know the interest you earn. You will never earn more than you expect. With share market investing, it’s up to company management to determine the amount of the dividend and when it is payable. The dividend is not guaranteed. However, quality companies generally increase dividend payments over time. If you elect to receive stock dividend distributions in lieu of cash, you add the magic of compounding. Each quarter the share count on which dividends are paid increases by the amount of the prior quarterly dividend. When you add increasing dividends to capital appreciation from a rising share price, the total returns to the shareholder can outperform fixed-income investments by a healthy margin. Academic studies from a variety of different disciplines have verified the historical advantage that dividend-paying stocks have over fixed-income investments. The most notable research examples can be found in the book, Stocks for the Long Run, by Jeremy Siegel, a professor at Wharton School of Business in the U.S.

Dividend payments are not guaranteed, but quality companies generally increase their dividend payments over time. Academic studies have verified the historical advantage that dividend-paying stocks have over fixed-income investments.

Dividend-paying Stocks—The Downside

The downside is obvious. Dividend payments can be cut or eliminated entirely if the company runs into trouble, regardless of the reasons. High yields from a company with a falling share price can be a sign that the dividend payment will not be sustainable in the future. With a fixed-income investment, your total return is virtually certain. With dividend-paying stocks, it is uncertain. You invest based on the belief that the company’s historical performance will continue and improve over time. There is no guarantee that a company will continue to pay dividends equivalent to those that it paid in the past, or even whether it will pay dividends at all.

Fixed-income investment gives you a certainty over your return. Dividend-paying stocks does not guarantee a return.

Dividend-paying Stocks—Sorting the Wheat from the Chaff

Finding quality dividend-paying stocks is not a matter of pure guesswork. You can track a stock’s history of dividend payments and spend some time evaluating the fundamental outlook of the stock. You can investigate how the stock is performing relative to the stock market as a whole and to its competitors. In an upward-trending stock market where the share prices of competitors are rising with the tide, a company going the other way could spell trouble. Researching the company can sometimes spot fundamental problems versus one-time events.

Perhaps the most valuable indicator of dividend stability is the Payout Ratio—a measure of how much of a company’s earnings is paid out in dividends. It is calculated by dividing dividends per share by earnings per share. A company paying out £5.00 per share in dividends with earnings per share of £4.00 has a payout ratio of 125%. Companies with that high a payout ratio can have trouble maintaining the dividend payment in the future. High-yielding stocks with lower payout ratios are often a better bet than the highest-yielding stocks with high payout ratios.

The payout ratio divides dividends per share by earnings per share and it measures the amount of company earnings that is paid out to investors in the form of dividends.

Summary and Conclusion

Dividend payments are a company’s way of sharing its success with its shareholders. It is up to the company to determine the dividend amount, and there are specific dates investors need to adhere to in order to receive the dividend. Although dividend yield (which is the dividend-per-share price divided by the price per share) is the easiest way to compare a given stock against a fixed-income investment, high yields can be deceiving. Investors need to do their homework to find quality companies with dividends that are sustainable over time. Look for increasing dividend payments over time and low payout ratios. Although the returns achievable with dividend-paying stocks lack the certainty of fixed-income investments, investing in quality dividend performers will lead to greater returns over time.

Summary:

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A dividend is a payment that is credited or debited into a shareholder’s trading account (depending on if a shareholder is buying or selling). A company generally emits dividend payments to attract more investors.

 

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The Declaration Date is when the company announces the dividend-per-share amount and the qualifying dates. The Book Closure date is when shareholders are eligible for the dividend payment. The Ex-Dividend Date is the date in which the dividend payment is released.

 

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Traders shouldn’t base their investing decisions solely on high dividend yields—most of the time, when a share price falls, the yield rises, consequently maintaining the same previous price for the dividend.

 

P

Dividend payments are not guaranteed, but quality companies generally increase their dividend payments over time. Academic studies have verified the historical advantage that dividend-paying stocks have over fixed-income investments.

 

P

Fixed-income investment gives you a certainty over your return. Dividend-paying stocks does not guarantee a return.

 

P

The payout ratio divides dividends per share by earnings per share and it measures the amount of company earnings that is paid out to investors in the form of dividends.

 

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