What Are Dividends and How Do You Calculate Them?
Owning $1 million dollars worth of stock shares increases an investor's net worth, but that investor can only become $1 million dollars richer by selling those shares. Dividends are the regular payments that investors earn for owning certain stocks.
What Is a Dividend?
A dividend is a form of return on investment. Certain stocks promise shareholders payments once a year or throughout the year that are a percentage of the profits the company has earned in that time period. Dividends follow a set payout schedule. Payments can happen every month, every six months, or once per year. Based on earnings, the company sets a dividend payment amount for each share of stock. Each stockholder earns the dividend amount for each share multiplied by the number of shares they own.
How Do You Get Dividends?
Investors earn dividends by buying shares of dividend-paying stocks before the ex-dividend date. An investor can determine whether or not a stock pays dividends by making sure that the dividend yield is above zero. If the dividend yield is below zero, the stock does not pay dividends. If it is above zero, the stock pays dividends.
Some companies publicize dividend figures. For others, investors can determine the figures from public financial statements. Subtract retained earnings at the beginning of the year from retained earnings at the end of the year. Then, subtract that number from the end of year net earnings. This results in the dollar amount of dividends paid during the year. Divide that number by the number of shares to find out how much of a dividend each share was worth.
Retained income is the amount of money, year after year, that the company keeps rather than sharing with shareholders. Net income is current revenue subtracted by expenses. All publicly traded companies are required to publicize clear financial documents. Even if a person does not understand the meaning of these terms, anyone can look in the right columns in the right months to pull the necessary information.
Dividend Calculation Example
First, pull the three key numbers from the company's financial documents.
January Retained Earnings: $500,000
December Retained Earnings: $800,000
Annual Net Income: $1,000,000
Then, use the formulas.
End of year retained earnings - beginning of year retained earnings = difference in retained earnings
Annual net income - difference in retained earnings = total dividends paid
$800,000 - $500,000 = $300,000 During the year, retain earnings grew by $300,000.
$1,000,000 - $300,000 = $700,000 During the year, $700,000 was distributed to shareholders as dividends.
How Do Dividend Stocks Work?
Each dividend payout has an ex-dividend date. Anyone who owned shares of the stock before that date receives a dividend payout. Although the most common form of dividend is a cash payout, some companies offer investors more shares at free or reduced prices. Preferred dividend payouts are set in stone, but these only go to certain investors who made bond-like investments with the company. If a company has a huge revenue event, the company may issue special one-time dividends sharing the increase with shareholders.
Except for preferred stocks, dividend amounts are not guaranteed, but companies aim to please investors in order to keep them. If a company does well, dividend payouts can continue increasing incrementally for years to come. Decreases in dividend payouts could spell a rapid loss of investors for companies that had a stable reputation in the past.
Why Buy Dividend Stocks?
Dividends stocks give investors a way of actively earning money from the shares they own without selling the stocks. Some savvy investors can use dividends as a main source of income after years of investing.
Buying dividend stocks forces an investor to invest in stable companies. A company that needs to use profits to pay for payroll, equipment, or other business functions will not offer dividends. A company that is so well established that profits can be shared with shareholders is a more stable investment. Only large companies with plenty of additional reserves to weather financial storms sell dividend stocks.
How to Evaluate a Dividend Stock
The most common ways to evaluate a dividend stock are analyzing the stock's dividend payout ratio, dividend per share, and dividend yield.
The dividend payout ratio is the percentage of income that the company shares with stockholders in a given time period. An 80% dividend payout ratio is optimal. Lower ratios are a sign that the company is more reliant on income than others. Higher ratios mean the company is more vulnerable to market changes.
To calculate dividend per share, divide the sum of all the dividends the company paid out in a given time period by the number of outstanding ordinary shares the company issued out during that time period. This shows the amount of money an investor could earn per share in a month, quarter, or year with the company in question. By comparing dividends per share, an investor could compare, for example, the amount of dividend income to be earned in a year from two different companies.
The dividend yield is the amount of annual dividend a share earns divided by the current market price of a share. If a $5 stock earns $1 in dividend payments per year, the dividend yield is ($1 / $5 = 0.20) 20%. That would be a very high dividend yield. In normal circumstances, most investors are looking for a yield closer to 4%, but higher yields are common in certain industries like real estate, oil-related industries, and certain sectors of the medical industry.
How to Invest in Dividend Stocks
Investing in dividends stocks is a simple as investing in companies that pay dividends. Although there are exceptions, companies with a dividend yield of 4% and a dividend payout ratio of 80% are seen as smart investments. When these numbers are higher, investors earn more, but companies often struggle to maintain or increase high dividends.
Companies with moderate dividends are safer investments that can remain lucrative for years into the future. Dividend per share is also an important metric based on budget. If an investor only has $1,000 to invest, they must determine if they will earn more dividends from buying several shares of a cheaper stock or from buying a few shares of a more expensive one.
Dividends add a level of stability to investing in the stock market, allowing investors to reasonably expect regular payments from their earnings.