Dividend stocks are shares of stock that pay out regular dividends to shareholders. They are considered to be safer investments because they tend to perform better over time than other types of stocks. But what exactly are dividend payments and why are they useful.

Throughout this post I will try to explain an overview of what dividend stocks are, how they work, and the risks associated. 

What is a Dividend?

A dividend is a payment made by a company to its shareholders. You could think of a dividend as like a reward or thank you for holding a companies stock. For example, if you own Coca-Cola stock ($KO) then you can receive an annual dividend yield of 2.72% of the stock price at the time of writing this.

Dividends are a great additional income as it means you don't have to sell your asset to make money. You can just hold it over time and, assuming the company is performing as expected, they will continue to pay you your dividend. You will get a dividend per share that you own so the more shares of a company that you have, the more dividends you will receive.

This is unlike interest where you need to take on debt in order to earn more money. So, dividends are a way to get paid without having to borrow money. It's also a way to diversify your portfolio as you can buy many different dividend stocks from many different sectors or sometimes even mutual funds and exchange traded funds which pay dividends

How often are dividends paid?

The frequency with which a company pays dividends varies from one type of stock to another. Some companies pay their shareholders once per year while some pay their dividend payment quarterly (4 times per year). However, there are some instances where companies may decide to pay with different frequencies such as monthly. It really is up to the company themselves so it's worth double checking.

When a company decides when a dividend will be paid, they will also public ally announce what is known as the ex-dividend date. The ex-dividend date is a date prior to the payment date of the actual dividend where you must own the stock to receive the dividend per share. In other words, if you didn't own the stock before the ex-dividend date, then you won't get the dividend. This is to prevent people buying the stock on the dividend date and selling as soon as it's received. 

So remember if you are looking to earn dividends on a stock, you must own the stock before the ex-dividend date - not on the ex-dividend date or after.

What is a special dividend?

Some companies choose to issue a special dividend instead of paying their normal dividend. This is usually done when a company has had a good financial performance in a particular quarter and wants to reward shareholders for their loyalty.

Special dividends are typically more of a 'one-off' payment compared to normal dividends but they still count towards your overall dividend pay-out and help grow your capital further. They're also a nice bonus as they can add a little bit extra to your total return.

Why Companies Pay Dividends

The main reason a company gives out a dividend to each shareholder is to generally keep them happy. You will often find that companies who are well established are a lot more likely to pay a dividend then companies who are new and still in their growth stage. The decision on whether to pay a dividend is done through the board of directors and it is also the board that decide the value of the dividend that will be paid.

It is often the case that the dividend can be paid to a shareholder when a company runs out of ideas on how to further expand there company so instead of the profit sitting in their balance sheets, they can pay their profits to their investors. This of course, incentivises more investors to purchase the companies stock, further increasing their valuation and share price. 

When a companies valuation and stock price is higher then they can raise funds much easier in the future if required for future endeavours.

Dividends will often be payed out in the form of cash, also known as cash dividends. There are some brokerages and providers which allow you to automatically reinvest your dividends through a dividend reinvestment plan so you can make the most of the compounding effect. These dividends can help grow your overall portfolio return over time by purchasing additional shares and increasing your earnings per share.

Taxes on Dividends (UK)

Similarly to income tax or other taxes, income from dividends also has be taxed. Thankfully we have the details here on exactly how this works.

Dividend Allowance

Just like with other types of tax, your dividend returns have an allowance in which you don't have to pay tax. This means you can make a certain amount during each tax year without having to worry about tax returns and how much you owe. For the 2022/23 tax year the dividend allowance is £2,000 however this may change each year so keep an eye out for the relevant tax year you are reading this.

Tax Bands

Once you are making enough in dividend income that you are over the dividend allowance then you will have to begin paying taxes on those earnings. If you are a UK shareholder (even for US based companies) then the 2022/23 tax bands are listed below.

See more details here: https://www.gov.uk/tax-on-dividends

What is a Dividend Aristocrat? Dividends over Time

A dividend aristocrat is a company that not only consistently pays a dividend but also continually increases the size of its dividends to shareholders. A company like this is often seen as a reliable dividend company as it shows that the company believes in the long term value of its shares.

This doesn't mean that all dividend aristocrats are good investments though. Some companies simply increase their dividends because they want to attract more investors into the market. Others simply increase their dividends because their business model requires it. It's important to understand why a company is increasing its dividends before investing in them.

Dividend Aristocrat Examples

Dividends for Mutual Funds and ETFs

It is often the case that some mutual funds and exchange traded funds (ETF) will contain stocks that pay out dividends. Due to this inclusion of dividend stocks, some of these mutual funds and ETFs will pay out dividends themselves. The dividends from these mutual funds and ETFS are usually distributed quarterly. Once again the payment dates may vary between mutual funds and ETFs so ensure you do your research before you make any purchases.

Summary

In summary, dividends are a great way to generate passive income and grow your capital. They are also a great way to diversify your investment portfolio. However, it is important to understand what type of dividend you are receiving and why the company is giving it out. Understanding these things will help you decide whether or not to invest in any particular company.

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FAQ

Why Companies Pay Dividends?

Dividends can be expected by the shareholders as a reward for their trust in a company. The company management may aim to honor this sentiment by delivering a robust track record of dividend payments. Dividend payments reflect positively on a company and help maintain investors’ trust. Dividends are also preferred by shareholders because they are treated as tax-free income for shareholders in many countries. (investopedia.com)

Why buy dividend stocks?

Stocks that pay dividends can provide a stable and growing income stream. Investors typically prefer to invest in companies that offer dividends that increase year after year, which helps outpace inflation. (nerdwallet.com)

How Do Dividend Reinvestment Plans Work?

A dividend reinvestment plan (DRIP) automatically purchases new whole or fractional shares of a stock when you receive its dividend. This is particularly helpful because it may increase the amount of dividends you receive in the future. Here’s how:

Let’s say you receive $20 as a dividend one quarter. If the stock price is at $20 per share, you end up getting an extra share of the stock. Next time dividends are paid out, the amount you receive will be based on the new number of shares you have, which includes your share purchased last quarter using a DRIP. This means your dividend payment will be slightly higher than it would have been otherwise. (forbes.com)

How Much to Invest in Dividend Stocks?

Your risk tolerance, investing time frame and income needs will determine the portfolio percentage to allocate to a dividend strategy. Remember, dividend stocks are not bonds, which guarantee the return of your principal. Like any stock, dividend stocks are subject to market and company-specific risks. (money.usnews.com)