Generally, dividends are considered a ‘Thank You Note’ from a company to its shareholders. But the value of dividends is much more than that. It is a part of the total return and could be a long-term wealth-building source.
The article below will help you understand dividends, how they work, and how they help investors to grow long-term wealth. Explore this beginner-friendly guide and learn all about the benefits of dividends.
What are Dividents?
Dividends are the rewards companies pay shareholders for their investment in the company. Paid from the company’s net profit, a dividend is a percentage of the company’s income distributed to shareholders as their share of the profit.
Dividends are either paid in cash or issued as additional shares, quarterly. It is the board of directors that decides the dividend amount based on the company’s most recent earnings.
The Mechanism: How do They Work?
Declaring a dividend primarily involves a crucial decision-making process by a company’s board of directors. They must decide together whether to pay dividends or not, and in what amount it must be paid – the individual amount as well as in total.
When the board of directores decide the amount of dividend, it is then reduced from the balance sheet of the retained earnings account of the company, which is an equity account showing the net balance of a company’s total earnings. The deducted amount will be reflected in the liability account of the shareholders.
There are four important dates related to the dividends. They are:
- Declaration Date: It is on this day that the company officially announces to pay dividends to its shareholders. The company notifies its shareholders and the market of its commitment on this day.
- Ex-Dividend Date/ Ex-Date: To receive the dividend, a shareholder must own the stock before the ex-date. The promised corporate benefit is only valid until the ex-date. From this day onwards, the stocks start to trade without dividends.
- Record Date: It is usually three business days after the ex-date. On this day, the company analyses its records to determine the eligible shareholders to receive a dividend.
- Payment Date: It is usually a month later than the record date. On this date, the company officially pays the dividends to its eligible shareholders, as decided by the board of directors.
It is the board of directors who fix the record date, payment date, and decide when to inform the shareholders.
The Impact of Dividend: Yield Vs Growth
The Dividend Yield
The dividend yield is the percentage of the total dividend paid by a company every year in comparison to the company’s total share price. It is the ratio of the gross annual dividend to its current share price, which can be used by shareholders to calculate their return on investment (ROI).
Dividend Yield(%) = Annual dividends per share X 100
Current Share Price
For example, if a company’s current stock price is $100 and the annual dividend it pays is $5 per share, then the dividend yield would be ($5 ÷ $100) x 100, that is 5%.
The dividends are usually paid quarterly. In that case, first multiply the last received quarterly dividend by 4 to get the annual dividend per share.
The Dividend Payout Ratio
The dividend payout ratio helps a shareholder calculate how much a company pays in dividends relative to its net income each year.
Here’s how you can calculate the dividend payout ratio:
Dividend Payout Ratio = Total Dividends / Net Income
For example, if a company’s net income is $500,000 and it pays a total of $25,000 in dividends, then its dividend payout ratio would be $500,000 / $25,000, or 20%.
The Growth Factor
It is said that a company with 2% yield that shows growth every year is way better than a company with a 5% stagnant yield. Even a small growth rate can compound to provide significant growth in dividend which can be reinvested for further future growth.
This growth-implied strategy is perfect for wealth building. Whereas a stagnant yield won’t provide such a growth potential. Investing in a company with a strong growth rate and a history of raising its dividend amount according to the growth will be able to provide more wealth-building opportunities for the shareholders.
Reinvestment: Turning Dividends into Wealth
The Dividend Reinvestment Plans (DRIPs) are a great way to build your wealth by buying more shares with the dividends, which will give compound interest over time.
Usually, when a company pays dividends to its shareholders, it is reflected as cash based on the number of shares they have invested. But if DRIP is activated, it will be used to purchase more shares in the company. This results in a compounding effect as the dividend amount rises with the number of shares. This growth cycle will provide a long-term wealth-building effect as it will increase the investor’s total equity and dividends.
One of the greatest examples of the rising importance of dividend-based investments is the S&P 500’s massive return. Around 23% of its ROI out of total returns in the last decade was through dividends.
The Risk Factors
While dividend-paying stocks are highly attractive among investors for long-term growth, they also have some drawbacks and risk factors that one must consider before making investments.
The Yield Trap
Most dividend-based investors are highly likely to choose stocks with high dividend yields. But this could be a trap. The unusually high value often indicates the unsustainable nature of the stock. Even though the high dividend yield makes the stocks more promising, this could be a signal of the financial crisis within the company, as the company is paying more than it can afford as dividends. This value could also drop significantly in the future.
Dividend Cuts
If a company reduces its dividend amount or completely stops paying dividends, it indicates that the company is currently facing financial instability or a crisis. Dividend cuts can trigger a drastic decline in the stock price of the company, as the investor sentiment will turn over.
Conclusion
Even though dividends have historically been a source of wealth accumulation, the percentage of total return could vary according to the market conditions. As the market landscape is marked by volatility and unpredictable events, investing in dividend-paying stocks can provide a more secure, high-potential income source.
During market volatility, these dividends can often provide substantial support for the investors. Also, for a balanced investor portfolio, it is important to know about dividends, even if the investor is into sudden wealth or long-term growth.
FAQ
Dividend aristocrats are the companies that come under the S&P 500 index by increasing their base dividend value for 25+ consecutive years. Whereas Dividend Kings are the elite ones that increased the dividend amount for 50+ years.
An investor can measure the safety by checking the payout ratio, which is the percentage of earnings per share (ESP) the company pays to its shareholders. Also, they can check if the company has a steady cash flow to ensure a consistent dividend payout.
Capital gains, where the return is through selling a stock for more than you paid, require perfect timing for good profit. While dividends allow generating passive income even when the market is down.
Dividend-paying stocks are mostly sought after by income investors, retirees, and value investors.
