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What Are Dividends And How Do They Work?

What Are Dividends And How Do They Work?

. 3 min read

What Is A Dividend?

A dividend is a payment that shareholders receive for their equity investment, and it usually represents part of the company's earnings.

As a practical example, let's imagine that one of your friends wants to open a new restaurant chain but doesn't have the funds required. To support his venture, you decide to invest in his restaurant project and become a shareholder.

The company generates a significant profit, so your friend wants to reward you and the other shareholders for your investment. He decides the best way to do that is to share a portion of the company's net profit with you.

He takes the idea to pay a dividend to the company's board of directors. The board approves the decision, and a few weeks later, you receive part of the company's earnings as a cash dividend.

Why Do Companies Pay A Dividend? And Why Some Don't?

When deciding how to utilize a company's financial resources, company management is expected to maximize shareholder value. If they use the company's cash to pay a dividend to reward shareholders, they can't use it to reinvest and grow the business.

To determine whether the company should pay a dividend, the board of directors considers the following:

  • Companies that are losing money or burning through cash rarely pay dividends because they need the capital to survive and get to profitability.
  • Companies in the early stages of growth often don't pay dividends because management needs the cash to reinvest into the business.
  • Profitable companies with a long track record often pay regular dividends because they have stable business models and are in the mature stage of the business life cycle. Such companies tend to grow at a slow or moderate pace but have the natural financial strength to sustain operations using cash flows from earnings. Instead of keeping excess cash idle on the balance sheet, these businesses opt to distribute profits to shareholders.
  • Specific legal structures like real estate investment trusts (REITs) are required to distribute at least 90% of taxable income to shareholders as dividends.

Which is better for you as an investor? If you invest to accumulate capital for the future and don't need your investment to generate a yearly income, it may not matter to you that a company doesn't pay a dividend.

By investing in the stock market, you can realize a return on your investment with dividends or capital appreciation. With dividends, you receive a direct payment for owning a stock, while with capital appreciation, you derive a return from an increase in your assets' value.

If a firm uses the funds to invest and grow the business, you won't receive any regular dividend payment. But if management's reinvestment efforts are successful, your return will be realized in the form of capital appreciation since the company's stock price will increase to reflect the growth in the underlying business.

How Often Are Dividends Paid?

There isn't a specific rule for the frequency of dividend payments to shareholders. Most companies pay dividends every quarter (in line with earnings reports) while some pay it annually, semi-annually (twice a year), or monthly.

The dividend frequency depends on the type of company. For some companies, such as REITs (Real Estate Investment Trust), it's reasonable to distribute a monthly dividend because they collect payment from their customers on a monthly basis. Companies in other sectors like Consumer Discretionary, where revenue is not evenly spaced throughout the year, tend to pay quarterly dividends.

Using the Finbox stock screener, I ran a screen for constituents of the S&P 500 Index. After exporting the results, I created a tally based on the dividend frequency. As of July 2020, there are 393 dividend-paying stocks in the S&P 500 Index. Of the 393 stocks, approximately 381 pay dividends quarterly, six semi-annually, three annually, two monthly, and one on an irregular basis.

If you want to find the dividend frequency of a particular stock, you can use the Finbox Data Explorer, as shown below.

find out how often are dividends paid with the data explorer