Dividends: Definition, how it works, and how to invest?

How Do Dividends Work

Dividends are often overlooked in favor of headline-grabbing stock price movements, but they quietly power some of the most effective investment strategies. Beyond just a regular payout, dividends can offer a pathway to financial freedom, compounding wealth in ways that capital gains alone often cannot.

In this blog, we’ll explore what dividends are, why some companies pay dividends, how to choose the right dividends, how to invest in dividend stock, and many more.

So, let’s get started.

Table of contents

  1. What are dividends?
  2. How do dividends work?
  3. Dividend paying companies
  4. Why buy dividend stocks?
  5. Why do companies pay dividends?
  6. Why some companies do not pay dividends?
  7. How often are dividends paid out, and how do shareholders receive them?
  8. Understanding the dividend payout ratio
  9. Special dividends vs. Regular dividends
  10. Should you automatically reinvest dividends?
  11. Taxing stock dividends: What to know
  12. How to choose the right dividend stock to invest in?
  13. How to invest in dividend stocks on Public.com?
  14. Value of dividend stocks in your portfolio

What are dividends?

Dividends are payments of cash or additional stock paid out to shareholders of public stocks on a regular basis.

When you buy a share (or shares) of a public company, you become a shareholder (aka a partial owner). When a public company is doing financially well or wants to promote shareholder interest, it may reward stockholders with dividends.

Companies usually pay dividends quarterly or semiannually, though it depends on the stock at hand how frequently (or not) this happens.

You can find out if a company pays dividends and how much they pay by looking at the dividend yield. This is usually one of the key metrics on a basic stock chart.

How do dividends work?

Dividends are regular payments that companies make to shareholders, usually from their profits. When you own a dividend-paying stock, you receive these payments, often quarterly, as a way to share in the companys financial success.

The dividend amount is set per share, so if a company declares a $2 annual dividend and you own 50 shares, you’ll receive $100. Many companies in sectors like utilities, finance, and consumer goods offer stable dividends, making them attractive for income-focused investors.

Investors can opt to reinvest dividends automatically through Dividend Reinvestment Plans (DRIP), which help compound growth by buying more shares with the dividend payout. Public.com offers the option to reinvest dividends automatically.

You can enable dividend reinvestment by following steps:

  • Go to your account settings on Public.com.
  • Turn on the option to automatically reinvest your dividends.

This strategy helps you accumulate more shares and grow your future dividend payouts.

Dividends can offer a steady income stream while potentially benefiting from stock price appreciation, making them a key part of a balanced investment strategy.

Dividend paying companies

Dividend-paying companies are typically well-established businesses with stable earnings and a commitment to sharing profits with shareholders. Many of these companies are found in sectors like utilities, consumer goods, healthcare, real estate, and financial services, where consistent cash flow enables them to distribute regular dividends.

Key characteristics of dividend-paying companies include:

  • Strong financial health: These companies often have healthy balance sheets and reliable cash flows, allowing them to maintain or even grow their dividend payments over time.
  • Dividend growth: Many companies increase their dividend payouts annually, making them attractive for investors seeking both income and long-term capital appreciation.
  • Blue-chip stocks: Large, established companies like those in the S&P 500 are common dividend payers, offering stability and lower risk.

Why buy dividend stocks?

Many investors use dividends as a form of passive income. The only prerequisite of receiving a dividend is being a shareholder of a dividend-paying company.

The caveat? Public companies may use dividends to court investors even when the stock price is decreasing.

Additionally, these companies are not required to pay dividends to shareholders. A company’s board of directors can decide to issue, cut back on, or eliminate dividends at any time. This is true even for stocks with consistent dividend payouts over a period of years or decades.

Still, dividend income is a legitimate income stream. Just remember that past performance is not an indicator of future results.

Explore high yield dividend stocks in 2024 and understand the reasons behind investing in dividend stocks; check out a list of public companies offering dividend yields of 3% or higher, providing valuable insights into the potential benefits of dividend investing.

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Here are a few reasons investors might choose to buy dividend stocks:

  • Steady income from regular dividend payments.

  • Potential for capital appreciation alongside dividends.

  • Lower risk due to stability and less volatility.

  • Compounding growth through reinvested dividends.

  • Hedge against inflation with rising dividends.

  • Sign of company strength and financial health.

  • Tax advantages for qualified dividends.

  • Portfolio diversification with income-generating assets.

  • Downside protection during market downturns.

Why do companies pay dividends?

Companies pay dividends to distribute a portion of their profits to shareholders, providing them with a regular income stream. This is especially common for mature companies with stable cash flows and fewer opportunities for reinvestment into rapid growth.

You may also see them in certain stocks that fall under the category of blue chip. Blue-chip stocks are public companies that are huge, mature, and have a solid reputation.

Key reasons companies pay dividends include:

  • Attracting and retaining investors: Dividends appeal to income-focused investors, particularly during uncertain market conditions, offering steady returns in addition to potential stock appreciation.
  • Confidence in financial stability: Regular dividend payments signal strong financial health, showing that the company is consistently profitable and has a reliable cash flow.
  • Rewarding long-term shareholders: Dividends help build shareholder loyalty, encouraging long-term holding of shares, even in volatile markets.

While dividend payments are often a good sign, it is important to note that extremely high dividend payments could be a red flag. Higher dividend payouts are difficult to sustain over a long period, so a person who invests in a company with high dividends accepts the risk of the company cutting back or eliminating payments at any time (as well as the natural risk of value loss in any stock).

Why some companies do not pay dividends?

Not all companies pay dividends, particularly those in growth-focused industries. Instead of returning profits to shareholders, these companies reinvest earnings back into the business to fuel expansion, innovation, and acquisitions.

The primary reasons some companies choose not to pay dividends include:

  • Focus on growth: Companies in sectors like tech and biotech often prioritize reinvesting profits to accelerate growth, develop new products, or expand market share, believing it will deliver greater long-term returns.
  • Early stage or high growth: Startups or companies in their early stages often hold back on dividends, opting to reinvest all available resources into scaling their operations and increasing stock value.
  • Stock buybacks: Some companies prefer stock buybacks, using excess cash to repurchase shares, which can boost the stock price and benefit investors by increasing earnings per share (EPS).
  • Volatility or uncertain cash flow: Companies in volatile industries may retain earnings as a buffer against economic fluctuations, ensuring they have sufficient capital for future investments or downturns.

How often are dividends paid out, and how do shareholders receive them?

The timing of a dividend payout differs from company to company. The most common cadence is quarterly. Some Real Estate Investment Trusts (REIT pronounced reets) pay dividends monthly.

Jargon alert!

A declaration date is the date a company announces it will distribute dividends to investors.

An ex-dividend date (aka ex-date) is the set deadline for dividend payouts to existing shareholders. The company owes dividends to any shareholders who buy the stock before that date. The company does not owe dividends to any shareholders who buy the stock on or after the ex-date.

The payment date is when the company actually distributes dividend payouts.

A dividend payment can come in two forms:

1. Stock:

A stock dividend pays an investor with additional shares of stock. For example, if an investor owns 20 shares of a company that pays a 5% stock dividend, the investor will receive 1 additional share as an annual dividend payment (5% of 20 = 1).

2. Cash:

A cash dividend pays investors with cash. For example, if an investor owns 20 shares at $10 each ($200 in total value) and the company offers a 5% cash dividend, the investor will receive $10 as an annual dividend payment (5% of $200 is $10).

For both stock and cash dividend payouts, you will receive the dividend payment on the payout date in your brokerage account. Some people choose to pocket dividends, but some people choose to reinvest their dividend payments back into the company.

The way a dividend is paid out may depend on what class of stock you own (aka preferred or common stock). As the name implies, preferred stock shareholders have priority over common stock shareholders. Preferred dividend stockholders usually receive their dividends earlier than common stockholders.

Did you know? If a company decides to skip a dividend payment they may be obligated to pay back this dividend in the future to preferred stock shareholders. They do not have this obligation to common stock shareholders.

Understanding the dividend payout ratio

The dividend payout ratio, aka dividend yield, shows you the proportion of the company’s earnings that the company pays out to shareholders as a dividend.

The dividend yield you see on a stock chart looks like a percentage (for example, some dividend-paying companies in the S&P 500 may have dividend yields around 25%, depending on the company and sector).

Here’s a simple equation to remember the dividend payout ratio:

  • Dividend Payout Ratio = Dividends Paid / Net Income

Special dividends vs. Regular dividends

Most dividends are regular, meaning companies pay them out on a consistent cadence. But that’s not always the case.

A special dividend is a non-recurring dividend. It may only be a one-time event and is not suggestive of long-term dividend payouts. You can find out if a dividend announcement is special or regular by looking up a stocks dividend history on the Nasdaq website.

Feature
Special Dividends
Regular Dividends
Definition
One-time payment to shareholders
Ongoing payments made at regular intervals
Frequency
Irregular; based on company discretion
Typically quarterly, semi-annually, or annually
Purpose
Often distributed from excess cash or profits

Part of a company's ongoing profit-sharing strategy
Predictability
Uncertain and not guaranteed

More predictable and often expected
Impact on stock price
Can lead to a temporary spike
Can provide stability and investor confidence
Tax treatment
Similar to regular dividends, but can vary
Generally taxed as qualified dividends
Example
Special dividend announced after a strong year
Quarterly dividend payments from a stable company

Should you automatically reinvest dividends?

Whether or not you want to automatically reinvest your dividend payouts into the company is up to you. Many investors will select this option if the stock shows signs of long-term growth. It can be an effective way to get compounded returns, aka cumulative growth from a series of gains and reinvestments.

The process of automatically reinvesting dividends is also called a dividend reinvestment plan (DRIP).

Did you know? The Public app offers automated dividend reinvestment. When you use this feature, we’ll invest any dividends you receive right back into the company that paid it out. This helps you build an effective habit and automatically compound your money over time.

Sign up today on Public.com and join a community of informed investors!

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Taxing stock dividends: What to know

Qualified dividends are subject to a capital gains tax, which can be lower than the federal income tax if you hold the stock position for a year or more.

There are two types of capital gains tax: Short-term and long-term capital gains.

Typically, the Internal Revenue Service (IRS) applies short-term capital gains to investments held for less than a year before selling. The IRS usually applies long-term capital gains to investments held for a year or more.

But it treats dividends differently.

Whether a cash dividend is qualified or non-qualified will determine what tax structure will apply.

A dividend is considered qualified if common stock is held for a minimum of 60 days or preferred stock is held for a minimum of 90 days before the ex-dividend date.

If a dividend is qualified, it is subject to the long-term capital gains tax rate, which is considerably less than the federal income tax rate. If a dividend is non-qualified, the capital gains tax does not apply, and it is subject to the investor’s ordinary income tax rate (which depends on their tax bracket).

The long-term capital gains tax rate can either be 0%, 15%, or 20% based on your annual income and marital status, whereas the federal income tax rate can fall anywhere between 10% and 37%. Within any income and marital bracket, a person will earn more after a long-term capital gains tax than they would after a federal income tax. For the diligent investor, dividends can provide great tax opportunities.

Even if you receive dividends in the form of stock or automatically reinvest your dividends, you still must pay taxes. The one exception to this is if you’re earning dividends in a tax-advantaged retirement account (such as an IRA).

How to choose the right dividend stock to invest in?

Look at past performance on stock charts through the Public app. Determine how consistent dividend payouts are over the quarters and years. Compare that to the stock price fluctuations during this time. Decide if the opportunity for dividend earnings outweighs the risks associated with the stock investment.

Here are the tips to consider when choosing the right dividend stock to invest in:

  • Look for a competitive yield compared to industry peers.

  • Ensure the dividend is sustainable by analyzing the payout ratio.

  • Assess financial health through revenue, earnings, and debt levels.

  • Consider companies with a consistent record of paying and increasing dividends.

  • Look for a solid track record of dividend growth over time.

  • Invest in sectors known for steady cash flow and dividends, like utilities or consumer staples.

  • Strong leadership can positively impact dividend policies and company performance.

  • Be aware of broader economic trends that may affect a company’s ability to pay dividends.

  • Spread investments to minimize the risk associated with any single sector.

Common dividend stock investing strategies

If you want to implement an investment strategy focusing on high-yield dividend stocks, you’re not alone. Many people earn regular income through dividend stocks, but they still must make their own investment decisions.

As a dividend investor, you must ask yourself, will you:

  • Reinvest dividends to buy more shares of the same company?
  • Use those dividends to buy stock in a different company?
  • Save the cash?
  • Withdraw and spend the money?

Be wary of anyone giving you cut-and-dry investment advice. Tailor your strategy to your own life, including current market conditions and your personal financial needs and goals.

How to invest in dividend stocks on Public.com?

Investing in dividend stocks can help you build wealth and generate passive income over time. With Public.com, you can easily invest in dividend-paying companies while taking advantage of fractional shares and community-driven insights.

Step 1: Set up your Public.com account

If you havent already, youll need to create an account on Public.com to begin investing. Heres how:

  • Sign up: Download the Public.com app from the App Store or Google Play, or go to public.com to create an account.
  • Verify your identity: Complete the KYC process by submitting the necessary documents.
  • Link your bank account: Connect your bank account to transfer funds into your Public.com account.
  • Deposit funds: Once your account is set up, deposit the amount you want to invest in dividend stocks.

Step 2: Research Dividend stocks

In the Public.com app or website, browse the stock lists to find dividend-paying companies. You can focus on important metrics like dividend yield and payout ratio to identify reliable dividend stocks with a history of consistent payouts.

Step 3. Choose and buy Dividend stocks

On Public.com, search for the stock youre interested in by its ticker symbol or company name. Once youve decided how much you want to invest, click “Buy,” and your order will be executed.

Step 4: Monitor your portfolio at one place on Public.com

After investing in dividend stocks, it’s important to regularly monitor your portfolios performance. Public.com provides easy-to-use tools to help you track your portfolio, stock price movements, and dividend payments.

Quick tip:

  • Quick tip: If you’re an impact investor, you may want to invest with the planet in mind. You can find sustainable dividend stocks on the Public app by looking at themes. For example, search through green power stocks to find ones that pay out dividends.

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Value of dividend stocks in your portfolio

Dividend stocks provide passive income for shareholders. With the right stocks, they can help investors generate wealth over the long term. In some cases, dividends signal a company’s financial health. In other cases, it’s a distraction from the share price. But in general, dividends are an effective addition to a broadly diversified portfolio.

Remember: Dividends are never promised, but a dividend investing strategy can still provide a valid form of passive income when done right.

Frequently asked questions

Can you use dividends to generate passive income?

Yes, some investors use dividends to generate a passive income stream over the long term.

How long do I have to hold a stock to get the dividend?

You must buy the stock prior to the date of record, which is the set date by which shareholders must invest in order to get paid for the upcoming quarterly or monthly dividend.

How do I take my dividends?

You can take your dividends as cash or stock, depending on what the company offers. If you get cash dividends, you can withdraw or reinvest in the company.

Can I get dividends from ETFs and mutual funds?

Some exchange traded funds (ETFs) and mutual funds pay dividends. These funds are baskets of stocks and securities, so you may receive dividends on any stocks within the fund that pay dividends. Dividend-themed funds will likely have higher dividend payouts.

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