Dividend Definitions – How Dividends work?

While dividend investing seems fairly simple, investors should pause occasionally and take the time to understand fully how dividends work to increase their chances of finding the best investment opportunities and achieving long-term returns.

Income investors generally are very busy sifting through corporate financial statements or running dividend discount models in search of the best dividend-paying stocks for their portfolio. Therefore, understanding just a few basic concepts of dividend investing can be sufficient for generating a modest stream of dividend income. However, to maximize the magnitude of that income, as well as minimize volatility and tax implications, investors must dedicate the necessary time to learn and understand additional nuances of how dividends work.

This article does not aim to be the ultimate and complete resource on the topic of how dividends work. However, this article will provide a foundation for a few basic dividend investing concepts upon which income investors can start to build their knowledge base through many additional resources available online and in print.

How Dividends Work? – The Basics

Dividends are periodic payments that equities use to transfer a portion of their earnings or assets to their stakeholders. The dividends designation generally applies to earnings payouts by certain types of equities, such as C-Corporations, to their shareholders. Alternatively, payouts from different types of equities – such as S-Corporations, limited liability corporations (LLCs), partnerships, estates, trusts, etc. – are technically designated distributions.

The distinction in terminology is important mostly for taxation purposes. Since equities generally pay dividends from their earnings, those payouts do not figure into the original cost basis of buying the stock. On the other hand, distributions are usually payouts of equity and figure into an investor’s cost basis for taxation purposes.

However, unless specifically noted, the term dividend will represent both dividends and distributions for the remainder of this text since most of the concepts and ideas generally apply to both types of payouts.

How Dividends Work? – Why Companies Distribute Dividends

While it might seem odd that a company would not use all its earnings to reinvest into business expansion, the main driver behind dividend distributions is to reward shareholders for their investment and trust. Happy investors who believe that a company is a good investment and will reward them over the long run are key to any company’s ability for raising capital in the future.

Additionally, investors constantly walk the tight line between holding their investments for long-term capital gains and trading some of the long-term returns for current disbursements of cash income. Furthermore, some investors prefer the certainty of immediate returns instead of the uncertainty of deferred gains in the future. Investors have developed entire analytic models, such as the Dividend Growth Model, to evaluate the optimal tradeoff ratio and the current fair value of future returns.

However, proponents of the Modigliani-Miller Theorem – developed by economists Franco Modigliani and Merton Miller in the 1950s – claim that dividend distributions have no effect on the level of long-term capital gains in perfect market conditions. These investors maintain that distributing dividends might be a good strategy only if a company has no other superior investment opportunities. Opposed to this theory are investors who believe that dividend distributions are signs of strong company performance. Data back-tested against historical market performances does indicate that companies with rising dividends outperform their peers in the long run.

How Dividends Work? – Dividend Types

Companies distribute dividends most frequently as cash payouts. The ease of cash dividend distributions benefits the company, is easy to manage and helps the investors. To distribute a cash dividend, companies or brokerages just mail dividend checks or arrange electronic transfers directly to an investor’s account.

However, companies have other methods at their disposal for dividend distributions. The in-kind dividend distributions category encompasses a whole slew of distribution types. While the most frequent type of in-kind distributions is stock dividends, other types include property dividends, bonds of the company distributing dividends, bonds of a different corporation, government bonds, accounts receivables and promissory notes.

Investors benefit from stock dividends because the Internal Revenue Service (IRS) treats stock dividends as stock splits. Therefore, the investors have no tax liability for the tax year in which they receive the stock dividends. Like for all stocks, the taxes on capital gains are not due until investors sell the shares. Cash dividends – unless classified as qualified dividends – incur taxation as ordinary income, which generally incurs at higher rates than capital gains.

Qualified dividends are special cash dividends that must meet specific IRS requirements to benefit from taxation at capital gains tax rates. Even without a full understanding of IRS requirements, investors generally can differentiate the dividend type by noting where the dividend income is reported on the IRS 1099-DIV Form. Ordinary dividends appear in the 1a box at the top of the form and qualified dividends appear in box 1b of the same form.

In addition to the regularly scheduled dividend payouts, companies may distribute occasional one-time special dividends to allocate assets and unplanned cash inflows or extraordinary earnings distributions. These special dividends can come from various sources, such as business divestitures, liquidation of investments, lawsuit awards, etc.

How Dividends Work? – Measuring Dividends

While the dividend yield – a ratio of the total annual payouts per share divided by the current share price – is the most basic dividend measure, investors must look beyond this measure as the yield alone can misrepresent the health of the company’s financials. A rising dividend yield is generally a desirable metric. However, the underlying cause of the yield increase matters greatly.

Because the yield moves inversely from the stock’s share price, a sudden share price drop – or a long and steady decline – will drive the yield higher even if the total dividend payout amount does not change. Even rising dividend payouts will rarely manage to compensate for the share price decline. Generally, the share price will decline much faster than the dividend payouts increases, and the asset valuation losses will exceed dividend income gains overwhelmingly to result in overall total losses.

To evaluate a company’s potential to maintain or increase its dividend payout levels, investors must pay close attention to the dividend payout ratio, which indicates what share of its earnings the company distributes as dividends. Investor’s normally seek a payout ratio between 30% and 50%. At that level, the company distributes a fair share of earnings to generate substantial income for its shareholders and retains enough of the earnings to cover business expansion investments and other spending items.

How Dividends Work? – Dividend Dates

Dividend investors must know and understand the function of the four dividend dates to maximize their dividend income. While many investors look forward to the Pay Date for the actual dividend distributions, the ex-dividend date is the most important date. This date determines an investor’s eligibility for the next round of dividend distributions. To achieve the shareholder of record status and claim the next dividend payout, investors must own the shares before the ex-dividend date. Investors who purchase shares on or after the ex-dividend date must wait another period to receive their first dividend payout. While still important, the Declaration Date and the Record Date are more administrative in nature.

Income-seeking investors can benefit from dividend-paying equities and collect sizeable income payments with basic understanding of the dividend distribution process and minimal effort by picking a few stocks from the Dividend Aristocrats list or investing in one of the ETFs that tracks the performance of high-dividend stocks. However, to maximize dividend income potential, investors should delve deeper into concepts and analytical models behind dividend distributions. Even small effort can reward investors with above-average income flows and tax savings that compound over extended time horizons for enhanced long-term total returns.

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