Dividends are payments made to shareholders (owners) of a company, paid out of the company's profits or expected profits.
U.S. companies usually pay dividends on a quarterly basis while non-U.S. companies often pay annually or semi-annually.
The dividend can be paid out as cash -- either sent directly to the shareholder or deposited in the shareholder's brokerage account -- or it can be reinvested into the company through the purchase of additional shares. This reinvestment can be done either directly through the company via a dividend reinvestment plan (DRIP) or through the broker. Depending on the broker, either whole shares only or fractional shares can be purchased in this manner.
At times, the dividend can also include return of capital rather than a portion of profits.
Why do companies pay dividends?
Some highly successful companies run into an odd conundrum -- they might be making too much money. That is, they're pulling in more cash than they could reinvest in their business at a high rate of return. Rather than redeploy that cash at low rates of return in at-the-margin projects, they simply return that cash to the company's shareholders.
Broadly speaking, you've got four types of dividend payers:
1) The Zero Yielder - These are stocks that don't pay dividends. Usually, they don't do this for one of four reasons: They simply aren't consistently profitable enough to pay dividends, they operate in a cyclical industry and need to maintain a strong balance sheet for when times turn tough, they're still at a point in their growth cycle where management believes that marginal profits can still be reinvested in the company at rates exceeding their costs of capital, or that management simply doesn't want to start paying a dividend, as it generally signals to the market a lost confidence that the company can grow and that the company is taking on a strategic shift.
2) The Low Yielder (cue Low Rider) - These are names with yields in the range of 1% to 2%. These are companies that achieved some degree of financial stability, but still feel that they can comfortably reinvest in the business for economic profits. Typically, this is where you see the highest rate of dividend growth, as both earnings and its payout ratio can be climbing at the same time. Their payout ratios are in the ballpark of 10% to 20%.
3) The Stalwart - Stalwarts produce tons of cash and redistribute much if not most of it to shareholders (40% to 70% of earnings). They simply can't reinvest all of it at rates above their costs of capital. These companies usually have at least a narrow economic moat which allowed them to get to this phase in the first place. There's not tons of growth ahead, but some, and the company is a long ways from running into a growth wall or, worse, starting a slow decline.
4) The High Yielder - These are stocks that pay yields in the mid single digits or higher. Typically, they're either forced to pay high yields because of their corporate structure (MLPs, REITs, royalty trusts, etc.) or they're businesses in decline, and shares are priced in such as way as to make the yields extremely high. With the former group, there's a lot to love: These are businesses that usually produce tons of consistent free cash flow and still have growth potential.
Why buy stocks that pay dividends?
Dividends come out of earnings. Or, more specifically, free cash flow. A consistent, rising dividend payment is usually a hallmark of a solid, well-run business that generates substantial, consistent cash flow. All things being equal, that equates to a relatively stable business and a stock that might be a little less volatile than the market at-large. In other words, they're usually lower risk than companies that don't pay dividends.
Many investors rely on dividends as a source of retirement income. Some companies have a history of increasing dividends as their earnings increase. The potential for increased income coupled with their lower risk profiles, makes dividend-paying stocks a particularly attractive choice for retirees.
Finally, when stocks go down, the yield of the stock often will put a floor under the share price. If the stock price falls by half, the yield doubles. That can be a very nice source of income while you wait for recovery. And it's peace of mind insurance.
And don't forget that qualified dividends get special income tax treatment. Essentially, dividends get taxed at capital gains rates. That also makes dividend income more attractive--especially for people in upper tax brackets.
The important dates
With dividends, there are four dates that are important. These are, in order of occurrence:
- Date of record
This one is pretty self-explanatory -- the day the dividend is announced. The announcement contains the amount, when the cash will be paid out, and to whom.
Also known as "ex-div", this is the date on which new purchases of the stock are no longer eligible to receive that particular dividend. The stock then trades "ex-dividend," that is "without" the dividend. On that day, the exchange reduces the price per share by the amount of the dividend. For most dividends and most stocks, you will hardly notice any price change, just because of the noise of daily trading, but for large dividends (such as the $3 special dividend Microsoft paid a few years ago), it's much more apparent. If you sell the shares on this date, you will still receive the dividend. Actually, if you sell the shares that are eligible any time before the payment date, you still receive the dividend.
Note, if you already own shares before the ex-div date, but buy more shares on or after the ex-div date, you'll still receive the dividend on that first group. You just won't receive the dividend on the new group.
Date of record
This is the settlement date by which you have to be the owner of record. Because it takes two business days for trades to settle, this is almost always two trading days after the ex-div date. So, if the ex-div date is this coming Tuesday, the date of record is Thursday. You have to enter an order to purchase a stock and have it filled on or before this coming Monday. You will be the owner of record on Wednesday when the trade settles, so you satisfy the "owner of record" requirement on Thursday.
Finally! This is when you actually receive the cash into your account. Another easy explanation. If your dividend is automatically reinvested into more shares by your broker or through a DRIP, then it will be done at one of the prices that the stock is trading for on this date, not the ex-div date or date of record.
Dividends and basis
For U.S. taxpayers, according to the IRS, cash dividends do not reduce the basis of a stock purchase. For instance, if your company pays an annual dividend of $0.40 and you bought at $30, you do not get to reduce your basis to $29.60.
If you are reinvesting the dividends in a taxable account, then each reinvestment is treated as a new purchase with its own basis. You cannot just add all the shares together and use your original basis (another way of reducing basis).
Here is an example: You buy 100 shares of $20 stock with a commission of $10. Your basis is 100 x $20 + $10 = $2,010. The stock pays a single annual dividend of 5% (the yield when you bought it, or $1 per share). Dividend time rolls around and you receive $100 for the 100 shares, of which you owe Uncle Sam $15, assuming a 15% tax rate. That $100 is reinvested into more shares, but now the price is $25, so it buys 4 shares.
Your basis is NOT $2,110 for 104 shares ($20.2885 / sh). (For why not, see below.) You can't use an average basis, even if the original and reinvested prices were identical, because you didn't take commissions into account (which are added to your basis when you buy). Instead your basis is as follows:
- 100 shares, $2,010 ($20.10 / sh)
- 4 shares, $100 ($25 / sh)
Going further, a year later, the company has raised the dividend 10% and you receive $114.40 in dividends (104 sh x $1.10 / sh). You'll owe Uncle Sam $17.16, again assuming a 15% tax rate. The money is reinvested at a price of $27. Your basis is now as follows:
- 100 shares, $2,010 ($20.10 / sh)
- 4 shares, $100 ($25 / sh)
- 4.237 shares, $114.40 ($27 / sh)
And so on.
A spreadsheet makes this much easier to track and Foolish investors will use one.
In other words, each purchase has its own basis and this must be tracked. The IRS does not allow basis of shares of stock to be calculated using an average basis. Mutual funds, yes (taxpayer's choice to use average basis or individual purchase basis). Stocks, no.
Now, it comes time to sell the shares. You sell before the next ex-dividend date, so you don't receive another dividend. Your sale price is $35 (it had a good run up) and you pay another $10 commission, selling your entire holding. How much capital gain do you have?
Well, you have 108.237 shares. You receive $3,778.30, net of that $10 commission. This is how it breaks out.
- 100 shares is 92.3898% of 108.237 so this gets that proportion of the total proceeds or $3,490.77 and your long term capital gain is $1,480.77 (proceeds minus basis).
- 4 shares is 3.6956% of 108.237, so this gets $139.63 and your long term capital gain is $39.63.
- 4.237 shares is 3.9146% of 108.237, so this gets $147.90 and your short term capital gain is $33.50 (you had these shares for less than a year).
It is because of the possibility of having a short term capital gain for some of the shares that one must track the basis of the individual purchases. Hold a company long enough, and it is possible to receive as many shares from the dividend reinvestment as were originally purchased. That makes selling those last ones, the short term ones, a significant taxable event.
For more information, see IRS Publications, below.
From the investor's point of view, there is not much difference between a stock split and a stock dividend. In both cases, you end up with more shares that are, individually, worth less (but the total dollar value remains unchanged). There are differences from the company's point of view, and they relate to how the company wants to handle the par value of the stock and the total amount in that account. (This account is in the stockholder's equity portion of the balance sheet.)
In a true stock split, the company technically calls in all of its outstanding shares and issues new shares totaling more than it called in. For instance, if there are 1 million shares outstanding and the company declares a 3-for-2 stock split, it calls in all 1 million shares and then issues 1.5 million new ones. The effect to the stock's par value -- the carrying value of each share of stock found on the balance sheet -- is to change it by the inverse of the split ratio. For this example, the par value would be 67% of the original par value. The total amount of dollars in the par value account remains unchanged.
What you are concerned about is your basis. This is also reduced by the same ratio. If you had 100 shares at $60 each before, you would have 150 shares at $40 each afterward, using the example of the 3:2 split.
Often, though, the company actually issues new shares in the form of a stock dividend. In the above situation, it would be in the form of a 50% stock dividend. The difference from the company's point of view is in the accounting. Here, it transfers retained earnings into an account called "common stock at par value," increasing that account's balance. In the above situation, if par value were $5 per share, then there would be a $2.5 million decrease in retained earnings and a corresponding increase in common stock at par value. Unlike with a stock split, there is no change in par value.
Some stock dividends are accounted for slightly differently, but the net effect is a movement of money from retained earnings into other accounts within the equity portion of the balance sheet. There's no effect for you, but the details matter to the company.
In this situation, your basis is adjusted downward depending on the amount of new stock received and the original basis of the stock originally owned. For instance, for a 20% stock dividend, if you had 100 shares at $30 and 200 shares at $40, your new basis would be $25 for 120 shares ($3,000/120) and $33.33 for 240 shares ($8,000/240).
Unless you receive cash in lieu of fractional shares of stock, neither stock splits nor stock dividends are taxable events to you until you sell the stock. However, you do need to keep track of the new basis for your shares. For more information, see Publication 550, Chapter 4, from the IRS .
Return of capital
At times, especially for large one-time dividends, part of the cash paid to the shareholder is a "dividend" and part is "return of capital." The former is treated as a cash dividend and is taxable in the year in which it is paid.
The return of capital, on the other hand, is not taxable. Instead, it actually lowers the basis of your shares. This is the only part of a "dividend" that does this.
For instance, if you own 100 shares at a basis of $2,010, as noted above, and the company pays a $5 dividend which includes $2 of return of capital, the basis for those shares will be reduced by $200 ($2 x 100 shares) to $1,810.
Never fear, though. The IRS is not giving up on its taxes (much as we can hope). It will get its cut when it comes time to sell the shares by increasing the total capital gain. To illustrate, suppose you sell those 100 shares at $25 each with a $10 commission. Without the return of capital, the gain would be $2,490 - $2,010 = $480. With the return of capital, the gain would be $2,490 - $1,810 = $680 (there's that $200 that you got returned showing up as an increase in the capital gain realized).
If the return of capital actually reduces the basis to below $0, then the basis becomes $0 and the difference is immediately taxable. For instance, if the basis for those 100 shares is $150, then the $200 return of capital would reduce the basis to $0 and $50 would be taxable that year.
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