What is a dividend?
At the highest level, a dividend is a payment of an investment asset or security, which is then distributed to the holder of that security. These payments will convert the market value of the security to a known cash amount in your portfolio. They can appear in any number of securities, but the most common varieties are from holding either individual stocks or ETFs (including bond ETFs).
For stocks, dividends are a company’s way of sharing a portion of its earnings with investors. When companies make money, they have two choices: reinvest in the business or share part of the profits with stockholders.
When companies share their profits with shareholders, they distribute it in the form of a dividend. A company’s board of directors determines the dividend payout. Typically, dividends are paid out quarterly, although some companies distribute on an annual or semi-annual basis. A company can also issue a special non-recurring dividend either individually or in addition to already scheduled distributions.
Some companies will still make dividend payments even if the business doesn’t realize a profit. This keeps the established track record of regular payments and helps ensure a more stable stock price around earnings announcements.
For this reason, some people aim to live off dividends. In a bear market, companies with established track records of dividend payments are less likely to make a cut. Many blue-chip companies that pay dividends tend to increase them over time.
Bonds are more straightforward: when a borrower takes on debt, they agree to a repayment structure, which includes both a full timeline when the debt must be repaid, as well as periodic interest payments along the way. There can be many types of structures – from a mortgage paid off in monthly installments to a simple bond only paid off at maturity – but by holding a diversified portfolio of bonds, you can expect to receive dividend payments over time due to the periodic payments and maturities in that underlying pool of bonds. These will be paid out to you as a cash dividend, allowing you to realize profits over the lifetime of holding the investment, not just when you choose to eventually sell the holding.
However, dividends are not guaranteed income. A company’s board of directors can reduce or eliminate a dividend payout based on other uses for the money or company performance. Stock dividends are unlike bonds, which pay a steady income or risk going into default. Dividend announcements usually cause a company’s stock or issuer’s bond price to move up or down in proportion with the dividend.
Why dividend dates matter
Dividend announcements and payments follow a certain schedule, which helps determine an investor’s eligibility to receive dividend payments.
Common dividend dates include:
Dividend announcement date: when a company or security formally announces that it will pay out dividends. Shareholders must approve the dividend before it can be paid out.
Ex-dividend date: aka the ex-date, when someone is no longer eligible to receive a dividend. For example, if the ex-dividend date is on September 7th, security holders who buy on this day or after are not eligible to receive the dividend. Investors who buy the security on September 6th or earlier (provided it’s a business day) will be eligible.
Record date: set for one business day after the ex-date, it helps determine who is eligible to receive dividend distributions. Security holders on record as of this date will be entitled to the dividend payout.
Payment date: when the security pays out the dividend. Investors who own the security should see the money, stocks, etc., in their accounts on this date or later.
Why dividends are paid
Companies pay out stock dividends for different reasons. Sometimes, they have a surplus of net profit and choose to distribute dividends to shareholders. This can increase the appeal of the company’s stock, as many investors like the extra income.
Some companies pay out dividends as a reward to investors for trusting the company with their money. It can help maintain investors’ trust and shine a positive light on the business.
Bond ETF dividends can happen for multiple reasons, as well, especially when holding a diversified pool of loans. Underlying loans will have partial “coupon payments” come due, which can be returned to investors, or loans can mature with the principal coming back to the investor, as well.
Forms of dividend payments
Most companies pay dividends in one of several ways:
Cash dividends: based on the amount per share. For example, a stock may pay a quarterly dividend of $5 per share. This means someone who owns 100 shares of the stock can expect a dividend payout of $500 every quarter ($5 x 100 shares = $500).
Stock dividends: Companies can opt to pay out stock dividends instead of cash. Unlike cash, which is taxed when distributed, stock dividends aren’t taxable until sold. This can give investors more flexibility since they get to decide when to take the tax hit. It’s also a bonus for companies low on operating cash that still want to offer a dividend. Stock dividends are similar to cash dividends. Shareholders get a certain number of additional shares based on how many shares they already own. For example, if you own 100 shares and the company pays a 10% dividend, you will get 10 extra shares for a total of 110 shares.
Property dividends: While this is not a common practice, some companies pay property dividends. This can be in the form of any physical assets the company owns, such as real estate, equipment, and so on. Another option is using shares of a subsidiary company for the payout. When the dividend is paid out, it’s recorded at its market value. Shareholders can opt to sell the asset or hold on to it for further appreciation.
One-time dividends: A one-time dividend payment, also known as a special dividend, is a non-recurring distribution of company profits to shareholders. It’s usually larger than regular dividend payments and can be tied to a specific event such as the sale of a large asset. This dividend can be in addition to regular dividends.
Bond dividends are almost exclusively cash dividends.
What is the dividend coverage ratio for a stock?
The dividend coverage ratio (or dividend payout ratio) is the ratio of a company’s net income as it relates to the dividends paid out to shareholders.
Companies that pay dividends use part of their net income to distribute the payments and keep the balance to reinvest in the business, pay off debt, build their cash reserves, launch new initiatives, and so on.
Here’s the formula to calculate the dividend payout ratio:
Dividend Payout Ratio = Company’s Dividend Payout / Company’s Net Income
A company’s dividend payout ratio can vary depending on how established the company is, plans for expansion or growth, history of dividend payouts, and so on. If a company is young and in a growth phase, it is more likely to reinvest most earnings. This could result in a lower payout ratio.
Advantages of dividend securities
There are several advantages to including dividend payout securities into a portfolio:
Income: Some investors seek dividend-paying stocks as an income source. While dividend income isn’t guaranteed, companies with long track records of payments are more likely to continue the practice. Dividends can be part of a well-rounded financial strategy for growing your portfolio and generating income.
Capital appreciation: Owning dividend stocks means you can get paid twice: when you receive your dividend payout and when you sell the stock (provided you realized appreciation on the sale). That’s because the share price of the stock can rise, increasing the value of your investment in the company. Blue-chip companies such as Enbridge, BCE, and Chevron tend to increase dividends over time.
Dividend tax rate: Unlike ordinary income paid out from employment, dividend income is taxed under a different rate. It can be lower than your standard tax rate, making dividends an advantageous income source. The rate is determined by your income and filing status and can range between 0 and 20%.
Stability: Companies with a long history of paying dividends typically continue the practice even in a bear market. This can mean a reliable and steady cash flow, especially from blue-chip stocks. Stocks that pay higher dividends tend to be established and less subject to market volatility.
Investors who don’t need the income from dividends can reinvest them. Some brokers allow the options to reinvest dividends automatically to make it easier. Keep in mind that if your dividends are paid out in cash, you’re still on the hook for taxes unless they’re in a tax-advantaged account.
Criticism of dividends
While dividends may seem like a good idea for both the company and investors, not everyone supports this practice. Critics of dividend-paying companies such as Warren Buffett believe that the best use for company profits is in expansion, research, development, etc.
A young company should focus on reinvesting capital in the business to fuel growth. This can benefit investors by increasing stock price and the value of the investment.
Some critics suggest that companies that pay dividends don’t have a strong plan for future growth. Therefore, it’s important to research the company’s stock and understand management’s plans for the future before becoming a shareholder.
Also, the impact of dividend investing varies based on the investor's income bracket. Investors paying lower tax rates may benefit from preferential tax treatment on eligible dividends, potentially enhancing their after-tax returns. Conversely, high-income earners might face a steeper tax burden on dividend income, potentially eroding some of the perceived benefits.
A strong focus on dividend stocks can also inadvertently lead to geographical and sector concentration within a portfolio. In the Canadian market, dividend-paying stocks are often overrepresented in sectors such as financial, energy, and utilities, and are predominantly domestically focused. This concentration can result in reduced diversification, limiting exposure to growth opportunities in other sectors or international markets.
