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Dividends 101 - What. Why. When. If.

byRoy M. Nov 13th, 2020

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Dividends are seemingly simple - A company’s directors choose to reward its shareholders. It can be either in the form of cash payments, or additional stocks, though cash is the more common form. But, there are some things that every investor should understand before considering this as part of their portfolio. Either you know nothing about dividends, or think you know it all, this is a recommended read for you.

Dividends are often incorporated into investment portfolios as a means of steady, passive income. It was mostly common for retired investors, but in recent years became much more mainstream for millennial investors everywhere. Many invest strategically at certain times in order to benefit maximally from dividend schedules. 

Why do companies pay dividends?

A company that regularly issues dividends is usually a company that is stable enough to do so. The benefit to the company of issuing dividends is that it garners confidence among existing and potential investors, and perpetuates demand for their stock. It acts as a demonstration that the company projects strong future earnings, and makes them an attractive prospect for buy-and-hold investors.

How much dividend does a stock give?

In the common case, dividends will be given as exact cash sums directly to the shareholder's account. Each share entitles its holder to an exact sum of money that will be given regularly when the dividends are payed. For example, for each share of Exxon mobil (XOM) held as of writing this, the investor will get 0.87$ every quarter (four times a year at known dates). As of writing this, the price of a single share of Exxon is 36.08$. This means that for investing 36.08$ the investor will receive, regardless of changes in the underlying stock price (assuming the dividends themselves won't increase or decrease) - 3.48$ per year, which is 9.64% a yield.

The advantages of these cash dividends are that they are considered known and steady income, and are unrelated to changes in the stock's price. A long term dividend investor will not bother with short term changes in the stock price, as they have no effect on the dividend sum.

Cash dividends Vs Stock dividends

A company might choose to issue a stock as opposed to cash as dividend is if they have a short supply of liquid cash, or rather save that cash for future growth. The advantages of stock dividends are:

  1. The shareholder can decide whether to keep or sell their shares. If they are optimistic the company will be able to use the cash saved by not issuing cash dividends to earn a better rate of return, they might choose to hold.
    If not, or if they’d rather have the cash to allocate elsewhere, they can choose to sell them.
  2. Shareholders don’t generally have to pay tax on stock dividends, up until they sell it. This allows them to better plan their taxes.

Whether cash or stock dividends are “best” depends on the future success of the company, which in turn depends on the shrewdness (and perhaps more luck than many will admit) of the investor. There are many who will have taken cash as opposed to stock dividends from companies like Apple and Microsoft, who are probably kicking themselves they didn’t stick with the stock value that has exploded over the years.

There is also a psychological aspect to stocks as opposed to cold hard cash. Holding stock in a company is a show of
commitment and faith. Take the cash, and you’re on your own when it comes to what to do with it next.

When are dividends paid out?

Usually, dividends are paid out quarterly (four times a year, like earnings reports), but there are some cases where a company might pay them semi-annually, or as one-off “special” dividends.

When do dividends increase or decrease?

Usually, When a company is performing well, there’s more room to pay shareholders higher dividends. But a company might choose to adjust their dividend payout due to changes in growth strategy. Companies have a choice between paying out dividends or reinvesting cash in expanding the businesses. If they decide they need lots of growth capital (as is always the case with young businesses and startups), they may decrease dividend payouts. The same applies to companies repositioning, or undergoing big overhauls in structure.

A company that has reached a steady rate of growth, or a certain milestone, might then decide to reward shareholders with an increased dividend payout. On the other hand, a struggling one may choose to decrease it.

Where can I find high-paying dividends?

Usually, the companies or industries that are consistently able to pay out high dividends are those who rarely need to restructure, reposition, or fuel growth. This is why utility stocks are favorable for passive investors. Everyone needs food, gas, water and electricity, even in recessions, pandemics, and war! Companies like Coca cola, Kraft Heinz, and oil and gas companies like Exxon are key examples of a high-paying stocks. Other examples are Southwest Gas Holdings and American Electric Power, which pay, as of writing this, an annual yield of 3.44% and 3.13% respectively.  Companies that have a history of consistently paying high dividends are often referred to as "Dividend aristocrats".  Surprisingly, you can also find 'Dividend aristocrats' in the technology sector, although these are very rare. An example is IBM, that currently pays a 5.96% annual yield.

In my opinion, a better way to be a dividend investor is with ETFs that specifically track many of these Dividend aristocrats, dispersing the risk of investing in one particular company.

High dividend ETFs

Some ETFs (Exchange Traded Funds) are also known to deliver reliable dividends. They’re often used for the express purpose of diversifying dividend income as opposed to retaining singular stocks. Those that track a large variety of large s&p 500 companies, are considered very low risk. Some notable high dividend ones are:

ETFDescriptionAnnual yield
VYMVanguard High Dividend Yield Index Fund ETF Shares
SPYDSPDR Portfolio S&P 500 High Dividend ETF
XLEEnergy Select Sector SPDR Fund

How do dividends affect the underlying stock price?

When a company declares they will be paying a dividend, or increase it's dividend, they naturally become more appealing to would-be investors who want to benefit from it. This (unless for some circumstances) usually leads to a surge in demand for the stock, driving up the price. The cut-off date (or ex-date) for new investors to benefit from dividends is usually two business days before the record date. Once this has passed, the stock price will be driven back down again, as there will no longer be the impetus of benefiting from the dividend.

On the one hand, the dividends come out of the company’s pockets, and therefore cannot be allocated towards research and development. This might ward off long term investors relying on growth. This is why, as stated, usually bigger and established companies would issue higher dividend yield. On the other hand, the same dividend is what attracts some investors in the first place. This is a trade-off.

How are dividends taxed?

How your dividend portfolio will be taxed depends on where you are in the world, how much you earn, and if your portfolio consists of qualified stocks, or unqualified stocks. A qualified stock is a stock that has:

  1. Been paid by a U.S. company or a qualifying foreign company
  2. Not been listed with the IRS
  3. Met the required dividend holding period.

Most US stocks will be qualified, and if the investor earns ordinary income and is taxed at a rate of 10-12%, they will pay 0% tax. If an investor pays income tax at a rate of 12-35%, they will pay a 15% tax rate. For those above the 35% tax rate, there is a 20% cap on dividend tax.

The main exclusions (unqualified stocks) are dividends paid by real estate trusts (REITs), via employee stock options, or by tax-exempt companies. In this case, dividends are classified as interest income, and are subject to income tax. This is why qualified dividends are preferable to unqualified dividends.

In the UK, those on the basic tax rate (with incomes up to £50,000) will pay a rate of 7.5% on dividends. Those earning an ordinary income of £50,000+ will pay 32.5%. Those on the additional rate of income, which is £150,000 or over, will pay 38.1% on dividend yields.

Are dividends a good investment?

Dividends are an excellent long-term option for those preferring low risk and steady growth. One fact you might not know is that they’ve been consistently shown to outperform the stock market. Some stocks (like the utility stocks we discussed before) are not a subject as others to market fluctuation, and even with those that are, consistent dividend payouts provide a counter balance to a more volatile share price appreciation.

Dividends also offer more flexibility. When one wants to cash out, he can usually do so in moments notice, unlike, say, real estate. Although, the latter is considered much lower risk. As stated before, since dividends are not a speculation investment, but rather a long term play for consistent cash flow, one shouldn't worry too much about the underlying stock price fluctuations. Let's look at an example for a dividend portfolio that yields 7% a year, considering none of the underlying stocks change their price. All dividends are reinvested when received.

That results in approximately x7.5 the initial investment after 30 years. In reality, large established businesses tend to appreciate and grow. Let's now also assume the underlying stock value rises a modest 2% a year as well on average:

Now the initial investment multiplies itself x13-fold over the course of 30 years. This perhaps sounds great, but like any good investment, comes with its risks. Businesses can go bankrupt, and the underlying stock price can drop. For this exact reason, dividend investing is best made using an ETF as we discussed, dispersing the risk among the world's top and most established businesses, diminishing the risk almost completely in the long run.

So - Are dividends better than real estate?

Looking at the above charts, it seems the answer is yes, purely from a numeric standpoint dividends are more lucrative than rent. But, there is a very important difference between real estate and dividends, that might tilt the balance towards the latter, and that is - Banks and institutions will gladly lend you money to buy a house (and insure their loan with it), but not to buy stocks or other paper assets. Also, these home buying loans are extremely cheap and if you take them at a fixed rate for 20 or 30 years, are extremely safe as well. This power of safely leveraging your initial investment with mortgage, can only be found in real estate. Therefore, there isn't a clear verdict here. You will have to figure out the path to your financial freedom on your own.

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NOTE TO THE BELOVED READERS OF MARKET ALERTS: The views and opinions depicted in the article are for educational use, and do not constitute financial, investment, or other advice.

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