The Modest Wallet is a free digital publication delivering its readers simple personal finance solutions. We regularly partner with brands that have products and services that will help our readers. When you buy through links on our site, we may earn a small commission at no extra cost to you. How we make money.
If you’re looking to earn passive income on a long-term basis, have you considered the perks of dividend-paying stocks? These are essentially blue-chip equities that distribute a percentage of the company’s earnings to shareholders, typically on a quarterly basis.
However, there is much to learn about what dividends are and how they work—which is why we have created the ultimate guide on all-things dividends. This includes a basic explanation of what dividends actually are, which types of companies offer them, how much is typically paid and how frequently, and anything else that we think you should know.
Let’s start by gaining an overview of what dividends are.
What are Dividends?
When you buy a traditional blue-chip stock listed on a popular stock exchange like the NYSE or NASDAQ, you are doing so with the overarching aim of making a profit. In order to achieve this, stocks typically offer two key mechanisms to yield profits for the shareholder.
Firstly, capital gains are where the value of the stock increases on the open marketplace, subsequently allowing you to sell your stocks for more than what you initially paid. The second key mechanism that will allow you to make a profit on your stock investments is via dividends.
The easiest way to think of dividends is that the company you have invested in decides to share some of its profits. If they do, you as a shareholder will have a right to your share of the profits, in the form of dividends.
- For example, let's say that company ABC reports a quarterly profit of $100 million.
- As the company has met its targets, it then decides to distribute 5% of these profits back to its shareholders.
- This would mean that company ABC releases $5 million back to its shareholders.
- The $5 million would be distributed to each and every shareholder, proportionate to the number of stocks they currently hold.
As we will discuss in greater detail later in our guide, it is important to note that not all companies pay dividends. For example, you might be surprised to learn that major companies such as Amazon, Tesla, Facebook, and Alphabet have never paid its shareholders any dividends, albeit, they have rewarded investors in the form of capital gains, instead.
So now that you have a basic idea of what dividends are, in the next section of our guide we are going to explain how they work in more detail.
How do Stock Dividends work?
In order to gain a firmer understanding of how stock dividends work, it is important for us to provide you with a basic breakdown of how the distribution process typically works.
1. Oranges PLC reports quarterly profits
Let’s say that Oranges PLC reports its quarterly results for the months covering April 2019 – June 2019. In total, the company made $50 million in profits over the course of three months.
2. Announces profit share
Not long after releasing its quarterly results, Oranges PLC announces that it is going to distribute 10% of its profits back to shareholders. This means that the company is going to release $5 million.
3. Working out your share
In order to work out how much of the $5 million you are going to be entitled to, we need to look at the current share price of Oranges PLC, and the number of shares you personally own.
Let’s say that in total, the company has 200 million shares in circulation, with each share worth $1. You currently have $10,000 worth of shares, meaning that you are holding 10,000 individual shares.
Oranges PLC is distributing $5 million across 200 million shares, meaning that each share would receive $0.025.
As such, your 10,000 shares would receive a total of $250 in dividends for the respective quarter.
4. Dividends are distributed
Finally, once shareholders have been notified of the amount of dividends that are to be released, Oranges PLC will then transfer the dividends in cash. This means that effectively, $5 million has now been withdrawn from the company’s cash flow account and subsequently transferred to shareholders.
The dividend payments will typically be sent to the account of your online stockbroker, who will then add the funds to your cash balance.
Do All Companies Offer Dividends?
As we briefly noted earlier, not all publicly listed companies pay dividends. On the contrary — some of the largest companies in the world do not pay dividends at all. This could be for a number of different reasons. For example, it is very rare for newly launched companies to pay dividends, not least because they need to reinvest their profits back into the business to facilitate growth.
At the other end of the spectrum, even firms that have been trading for decades on end choose not to pay dividends. Think along the likes of Amazon — one of the largest companies in the world that even to this day, has never paid a single dividend to its investors. Instead, Amazon has rewarded its shareholders in the form of long-term capital gains.
One of the key reasons that companies like Amazon do not pay dividends is that they are constantly looking at new operating streams to grow the business. Whether it’s investing in research and development or acquiring new companies, Amazon prefers to use its free cash flow to keep the business growing.
Why Buy Dividend Stocks?
Choosing strong and stable blue-chip stocks that have a good history of paying dividends comes with an array of benefits. Here are some of the main advantages of owning dividend-paying stocks.
Regular Income Stream
One of the overarching benefits of owning dividend-paying stocks is that you will be accustomed to regular income streams. This is highly attractive to investors that seek a form of passive income.
Even if the stock price of the equity in question is stagnant in the markets, investors can still keep their portfolio ticking along when dividend payments are distributed. As we will cover in the next section, this then allows you to use the cash to invest in other income streams.
Re-invest Dividends for Compound Interest
Dividend-paying stocks allow you to benefit from long-term compound interest. For those unaware, this is where you essentially earn interest on your interest over the course of time. This is further amplified when you constantly top up your interest-earning portfolio on a frequent basis.
By receiving dividends and then re-investing them into other income streams, you can grow your wealth considerably faster. In fact, you could even use the dividends to purchase additional shares in the company that you received the dividends from!
Strong and Stable Companies
If you own a stock that pays dividends, then it's likely that the company is relatively strong and stable. This is because companies can only pay dividends when they have strong earnings and healthy cash flow levels.
This also means that you're likely to see less stock price volatility on the markets, which is a further benefit for you as a risk-averse investor.
Multiple Earning Opportunities
If you invest in a company that does not pay dividends, then you can only make profits in one way — capital gains. However, by owning a portfolio of dividend-paying stocks, not only will you earn passive income from the dividends itself, but also from long-term capital gains.
Strong performing companies will often raise the size of dividends that they pay, which is an added income opportunity.
When are Dividends Paid?
In the vast majority of cases, companies will distribute dividends on a quarterly basis. However, some companies might decide to do this bi-annually, or even annually. Irrespective of how often a company does decide to pay dividends, the process is largely the same.
Firstly, the company will determine whether or not to pay a dividend once the periodic income statement has been finalized. Once it has, the board of directors will then meet to decide how much to distribute.
As you’ll likely remember from earlier in this guide, the amount distributed is based on a percentage of net income. For example, if the company made $40 million in quarterly profits, and it decides to release 5%, then it will distribute $2 million back to its shareholders.
Once the dividend decision has been made, the company is then legally required to announce this into the public domain. Known as the ‘Dividend Declaration Date', the company will announce the size of the dividend, the date that it will be paid, and the record date.
For those unaware, the record date refers to the date that you must have been a shareholder in order to benefit from the dividend payment. For example, if the record date was 25th October, but you sold your shares on 24th October, then you would not receive the dividend payment. This is why it is sometimes worth being selective with when you sell your dividend-paying stocks, not least because you might miss out on a dividend payment by selling too early!
Finally, once the payment date arrives, the company will release the funds to your respective stockbroker. In turn, your stockbroker will then credit the dividends to your cash account.
How is the Number Decided?
First and foremost, it is important to note that there is no hard and fast rule as to how a company determines its dividend payout. On the one hand, whether or not a company pays a dividend — and to what size — is typically determined by ‘performance.’ In other words, the better a company performs, the more ammunition it has to reward shareholders with a dividend payment.
The key problem with this argument is that it is not always the case. For example, take a look at major tobacco giant British American Tobacco. This super-strong company has had a turbulent time on the stock markets over the past two years.
This has been a result of increased regulatory pressures and an ongoing reduction of sales across the industry in its entirety. However, although British American Tobacco’s share price has taken a beating, it has reacted by significantly increasing its dividend payments. In fact, recent quarterly payments have been as high as 7% for shareholders, which is huge.
So with that being said, the size of the dividends that you receive will ultimately depend on the policy set by the company's board of directors.
Taxation on Dividends
The specific tax treatment on your dividend payments will depend on a range of factors, such as where you reside and how the dividends are classified by your respective tax authority. However, if you’re based in the US, then this is typically determined by whether the dividends are classed as ‘ordinary’ or ‘qualified’.
Let’s quickly breakdown the difference between the two.
Ordinary dividends vs qualified dividends
Firstly, if your dividends are classed as ‘ordinary', then they will be accustomed to the ordinary dividend income rate. This varies from 0% right up to a whopping 39.6%. Alternatively, if your dividends are classed as qualified dividends, then the tax rate will either be 0%, 15%, or 20%.
As such, from the perspective of tax liabilities, it is significantly more beneficial if your dividends are qualified dividends. So what's the difference between the two? Well, in order for your dividends to be classed as qualified, they need to meet two key criteria.
Firstly, you need to have held the stock for at least 60 days within a 121 day period. This is to prevent investors from simply buying and selling the dividend-paying stocks as a way to take advantage of beneficial tax treatment.
Secondly, your dividend-paying stock needs to be a U.S. company or a foreign company listed on a major U.S. stock exchange such as the NASDAQ or NYSE.
If the company doesn’t meet the above two criteria, then it will be classed as a non-qualified stock and thus you’ll pay a higher rate of dividend tax.
What is a Dividend Aristocrat?
A dividend aristocrat is a company that has a long-standing track record of consistently increasing the size of its dividends. In fact, in order to reach the status of a dividend aristocrat, the company must have increased its dividend payments for a period of at least 25 years.
In the vast majority of cases these will be large, established companies that are no longer able to enjoy significant growth levels. Moreover, such companies typically operate in a sector that is recession-proof, meaning that they enjoy steady profits irrespective of how the underlying economy is performing.
At the time of writing, just 57 companies listed on the S&P 500 can claim to hold the title of dividend aristocrat. One of the longest standing companies that falls within this elite club is Abbott Laboratories, which has increased the size of its dividend payments consecutively for a remarkable 46 years.
Other notable companies includes AT&T, Walgreens Boots Alliance, and Cintas. The best way to find a dividend aristocrat is to look for established companies that have historically implemented a stable dividend policy.
If you’ve read our guide from start to finish, we hope that you now have a full understanding of what dividends are and how they work. Not only this, but you should also know the importance of including dividend-paying stocks within your wider investment portfolio. In doing so, you’ll stand the chance of receiving regular income streams that you can then re-invest.
However, it is important to remember that you should not invest in stocks purely because they pay dividends. For example, while companies like British American Tobacco has recently been paying a juicy dividend of nearly 7% in order to reward investors for its poor performance on the stock market, this is still well short of the equity’s reduction in value.
As such, you should still evaluate the wider prospects of the underlying company, because capital gains are just as important as dividend payments.
Download our FREE
“Stock Market Playbook” eBook
Learn everything you need to know to invest your first $500 in the stock market and become a do it yourself investor