What Is a Dividend and How Do They Work? [Beginner’s Guide]

INVESTING - INVESTING BASICS
A dividend provides regular income from certain types of stocks you own. Here's how dividend stocks work and how to find them.
Updated April 3, 2023
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When you invest, what do you picture doing with your money? Taking a dream vacation? Being able to retire when you want? What about having money coming in regularly? Investing in dividend stocks could provide regular income that comes in from your investments.

Typically, dividend-paying companies are part of the S&P 500 index. These are growth companies with a total stock market value of outstanding shares (also known as the market cap) of at least $5.3 billion.

But what is a dividend and how does it work? We'll answer those questions and show you how dividend income could be a part of your investment strategy.

In this article

What is a dividend?

Dividends are payments to investors received from company earnings. In the U.S., companies usually pay dividends quarterly, monthly, or semiannually. A company's board of directors must approve each dividend ahead of time. The company then announces when the dividend will be paid, the dividend amount, and the ex-dividend date. Dividends are usually paid out in cash.

Certain industries are known for offering regular dividend payments. However, not all stocks in these industries offer dividends. Stocks in the consumer staples, financial services, real estate, and energy sectors are among the most popular high-dividend stocks.

How dividends work

Dividends are calculated based on the number of shares you own. For example, let's say a company declares a $2 per share dividend. If you own 100 shares, you will get $200 in dividends.

Here’s a more detailed example of how companies calculate and pay out dividends:

  • Step 1: A company's board of directors announces it will pay a dividend. This announcement is called the dividend declaration date. No money or shares exchange hands — it's just a type of disclosure.
  • Step 2: The company decides which shareholders will get a dividend. Two different dates determine who receives company dividends: the record date and the ex-dividend date.

The record date is the date the company management looks at their shareholder records to see who can get the dividend payment. The ex-dividend date is the date on or after which investors who purchase shares will not receive that quarter’s dividend. The ex-dividend date is one day before the record date because it takes three days for a trade to settle for cash and shares to go into investors' hands.

Shareholders who own shares before the ex-dividend date will receive the dividend payment. If you bought after the ex-dividend date, you may still be entitled to future dividends.

  • Step 3: The day the company plans to pay out the dividend is the payment date. It is the official day on which shareholders receive the dividend. Again, you must be part of the group that purchases shares before the ex-dividend date in order to get the dividend.

Types of dividends

Dividends are usually paid in the form of a dividend check. However, companies may also pay them out as additional shares of stock or through other methods. Let's walk through some different forms of dividends.

  • Cash dividends: Cash dividends refer to the type of dividends in which companies pay cash directly into the shareholder's brokerage account.
  • Stock dividends: Companies sometimes pay investors with shares of stock instead of with cash.
  • Dividend reinvestment programs (DRIPs): A dividend reinvestment program (DRIP) means you reinvest dividends back into the company's stock instead of putting the money into your bank account. Companies usually do this at a discount. Putting money into an account and continuing to reinvest for decades could help you realize extensive compounding benefits.
  • Special dividends: A company sometimes surprises its shareholders with additional dividends called special dividends. Companies typically pay out special dividends one time and stockholders usually receive more than they would have received with a regularly recurring dividend.
  • Preferred dividends: Stockholders who own preferred stock receive preferred dividends. Preferred stock simply means that shareholders do not have voting rights, unlike when they invest in common stock. Preferred stockholders receive payment first if, for example, a company goes bankrupt or merges with another company. Preferred dividends are more like bonds than stocks because they typically offer fixed dividends.

How do dividends get paid out?

Dividends are drawn from a company's earnings and paid out periodically through the methods described above. You’ll also want to pay attention to the dividend payout ratio (DPR), which is the ratio of the total amount of dividends paid (DP) out to shareholders relative to the company's net income (NI). This is expressed in the following formula:

DPR = Dividend Pay Out (DP) / Net Income

A high DPR could indicate that a company is reinvesting less of its earnings back into the business and choosing to pay out more to investors. This is typically the case with more well-established companies with a slow but steady growth rate, including many blue chip companies like General Motors and Coca-Cola.

Companies that report low DPRs are investing more of their earnings back into their business. These are usually young and fast-growing companies looking to expand and grow. As a result, they pay lower dividends to their investors and tend to look more toward growth investors seeking to make a profit from the company’s future rise in share price.

How to invest in dividends

First, identify the type of investments that pay dividends you'd like to own. Here are three common types:

  • Stock: A share of stock means that you own a small portion of a company.
  • Exchange-traded fund (ETF): An ETF is a basket of securities traded on an exchange that contains investments, such as stocks and bonds. ETFs sometimes track an index such as the S&P; 500.
  • Mutual fund: A mutual fund is also a basket of securities. It’s a pool of money taken from many investors to invest in securities, such as stocks, bonds, and other assets.

Next, you'll need to open a brokerage account and put money into it. You can choose from a variety of online brokerages, such as Robinhood or M1 Finance . An online brokerage isn't your only option, though. You can also open an account with a financial advisor or buy stocks directly from a company through a direct stock plan.

Before you choose the right option for you, you may want to shop around. Look into fees, account minimum requirements, services, a platform’s ease of use, tools available on the brokerage platform, and more.

Next, choose the company or companies you would like to invest in. Usually, companies that pay dividends have a track record of success and good past performance on returns. It's a good idea to do your research so you know which companies offer the best returns.

For example, you may consider established companies you already know, such as those that trade on the S&P; 500 index, which features 500 of the leading U.S. publicly traded companies. It's a good idea to take a deep look into what drives a company’s earnings as well as how it’s managed.

Here are a few good questions to ask. Many tools, as well as the company's financial statements, can help you assess the answers to these questions:

  • How does this company make money?
  • Does the company have a great management team?
  • How does the company stack up against its competitors?
  • What is the company's business model?
  • What is net income growth from year to year?
  • What are the company's profit margins?
  • What does the company's cash flow look like?

Next, decide how much stock you want to buy. If you have a brokerage account, you may be able to simply choose how much money you want to invest in one or more stocks.

Finally, keep track of your stocks and the dividend announcements of each company you invest in. You want to keep track of the performance of each company. Just remember that it's possible that the longer you keep your money in a dividend-producing stock, the more likely you could benefit from your investment over time.

FAQs about dividends

How do dividends work?

Dividends refer to how companies distribute their earnings to shareholders. Companies that pay dividends give a set dividend policy for making payments, which can be quarterly, monthly, semiannually, or annually. You may receive dividends in the form of cash, additional shares of stock, or as dividend reinvestment programs (DRIPs).

Are dividends free money?

Investors often assume that dividends are free money, but they are taxed based on whether you receive non-qualified or qualified dividends.

Qualified dividends are dividends from shares in domestic corporations and certain qualified foreign corporations that you have held for a specific holding period. These dividends are taxable on the federal level at the capital gains rate, which depends on your adjusted gross income (AGI) and taxable income. Note that the capital gains are taxed at a lower rate than ordinary income. By contrast, non-qualified dividends‌ may be taxed at your ordinary income tax rate, which could go to a much higher percentage.

It's a good idea to consult IRS Publication 550 for details on qualified or non-qualified dividends because there are many rules that govern both types of dividends.

Why don’t some companies pay dividends?

A young or new company may choose not to pay dividends because it wants to invest as much as possible into its current growth structure. Companies that have been growing for a while may also choose not to pay dividends because they may have other priorities. For example, they may believe they can increase value by reinvesting their earnings into the company instead of paying dividends to shareholders. It's often a matter of company priorities.

Bottom line

There's no denying that dividend stocks fit neatly into a broad-based portfolio for many investors. However, it's normal to question whether dividend investing makes sense for you. As you’re learning how to invest money, you may find that investing in non-dividend-paying securities aligns more closely with your future goals.

FinanceBuzz is not an investment advisor. This content is for informational purposes only, you should not construe any such information as legal, tax, investment, financial, or other advice.

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Author Details

Melissa Brock Melissa Brock works as a freelance writer and full-time financial editor covering higher education, investing, personal finance, mortgages, saving for college, insurance, and more. Her work has been featured on Entrepreneur, Investopedia, The Balance, MSN Money, Yahoo! Finance, The Journal of College Admission, and more.

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