Dividends and Dividend Investing

A dividend is a profit distribution paid by a company to its shareholders. The profits may originate from normal company operations or from the organization's investment activities. The company's board of directors determines and declares cash dividends periodically – typically on a quarterly, semiannual, or annual basis. They can be paid to shareholders in the form of cash or as additional shares of company stock, though stock dividends are usually only issued when the board wants to reinvest cash profits to fuel future company growth.

The shares of stock that an investor buys represent equity (or ownership) in the issuing company. If that company pays a dividend, each share owned entitles the investor to a proportionate share of the total dividend to be distributed. For example, if Investor Smith owns two thousand of shares of ABC Corporation and the Board of Directors declares a cash dividend of fifty cents, Smith would receive a total dividend amount of $1,000. Or, if Smith's two thousand shares were to represent 2 percent of the total amount of outstanding stock certificates of the corporation (which in this example would be 100,000), Smith would be entitled to 2 percent of the total dividends.

As previously stated, company management determines if dividends will be distributed to shareholders, and if so, the form and percentage of overall earnings that will be paid out in relation to the amount retained and reinvested to further the organization's growth. This ratio of dividends paid out relative to the amount of earnings retained is known as the payout ratio. In addition to profit earned by the company, other factors can influence the board's dividend decisions, such as tax law changes and investor preferences. Dividend increases often lag substantially behind earnings increases because management generally wants to be certain that a new higher dividend will be sustainable in the future. This is because a reduction in dividends is usually perceived as a corporate sign of financial weakness.

Although some companies do experience financial difficulties that require them to reduce or completely stop their payment of dividends, the majority of dividend-paying businesses not only maintain the payouts that they establish but also attempt a policy of steady dividend increase for their investors. Some companies increase dividend payments quarterly, some annually, still others increase only as profits allow. Some companies even pay special dividends if earnings have been strong over an extended period of time.

Whenever the board of directors declare or make changes to a dividend payment, two important dates are also established: the record date and the distribution date. The record date is the date that the corporation finalizes its books for that financial period. Everyone who is listed in the books as a shareholder at the end of that day will be paid a dividend. After the record date, the stock trades ex-dividend (without the dividend). In other words, if the stock is sold, its price is reduced by the declared dividend amount because the purchaser won't receive the current dividend. The distribution date is the date that the shareholders of record are actually paid the dividend, generally several days to several weeks after the record date.

Dividend investing works quite well for many investors, for a number of reasons. For instance, dividends, needless to say, provide a steady stream of income – income that can be counted on whether the market moves up or down. This stream represents spendable cash which can be used or reinvested. Reinvestment allows the overall investment to grow at a compounded rate of increase. If quarterly dividends are used to buy more shares of stock, at the end of each quarter more and more owned shares will each be earning dividends, greatly increasing the total income stream. This is in addition to the fact that stock values historically increase over time. The new shares that are continually acquired with dividend revenues will also increase, simply adding to the value of the overall investment.

Additionally, dividend-paying stocks generally are not as volatile as other stocks. Because of the added benefit of a reliable dividend return, the investor faces less risk. This is even more important in a declining market, when investors can't count on price appreciation to give them the returns that they need. During these times, many will often buy dividend-paying instruments, stabilizing their price even further and causing the typical dividend-paying stock to fall much less than the equity market as a whole.

Dividend investing also promotes dollar cost averaging. Regularly and systematically acquiring more shares leads to a lowering of the average purchase price of the shares as the stock's price fluctuates. When prices are high fewer shares are purchased, but when prices fall more shares are bought with each dividend payment.

Without dividends, overall market performance would be quite lackluster, to say the least. It's common knowledge that over the last one hundred years, stocks have an average annual rate of return of 10 percent. It's not widely reported, however, that the rate is generated almost equally between price appreciation and dividends. Without factoring in dividends, the Dow Jones Industrial Average (DJIA) over the past century is only 5.2 percent, certainly nothing that would set most investors ablaze with excitement. Yet in a bull market with strong price appreciation to seduce them, many investors typically forget about the consistent returns and safety benefits afforded by dividends.

It should be stated that dividend-paying stocks work well in both overperforming and underperforming market cycles. During weak stock market performance cycles, dividends provide a positive return on investment that can be used to counterbalance a negative or nonexistent price appreciation. And in times of strong market performance, dividends can give an additional boost to the returns generated by increased share prices.

Under virtually any market conditions, history has provided strong and compelling evidence of the benefits of dividend-paying stocks. These benefits are applicable to and can be useful for all investors, from beginners to those who are already in retirement. With the addition of dividend reinvestment, they can also enjoy the advantages of increasingly greater income streams and a much larger and more valuable overall investment.

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