How do dividends work?

How do dividends work?

Dividends are the company’s way of sharing its good fortune with its owners – the stockholders. The basic idea is to distribute all some or all of the profits, as the company has no reason to hoard it. First off, there are two kinds of stock: preferred and common.

The former often comes with privileges (such as guaranteed dividends, increased voting power) but most people deal with what is known as common stock; the stuff lowly small fry like you and me trade on the stock market. For simplicity, we’ll only discuss common stock here.

Dividends are paid out based on the number of shares you own. Person A, with 1,000 shares, gets half as much as person B who has 2,000 shares. You’ll typically see this mentioned as X cents per share. These X cents per share can be paid out quarterly, annually, or semi-annually. There can also be special dividends, where the company simply decides to unload a windfall from, say having sold a division, or scored an extremely profitable deal.

But since shares change hands at a frantic pace, how is “ownership” decided when it’s time to mail out the checks? There are a couple of dates of interest for determining this. First, there is the declaration from the board. Basically, the company leaders announce that a dividend is coming, and when. This serves as a heads-up to existing and potential investors alike.

Next comes the record date. This is the day on which you must own the shares. But it’s not quite that simple; SEC rules state that your trade must be settled at least 3 days prior to the record date in order to be eligible for the dividend. This is intended to level the playing field and ensuring that any lags from different brokerages are straightened out. Hence, the owner at closing time 3 days out is what counts.

Technically, the owner could sell it the next day – before the formal closing date – and still reap the dividends, while the new owner gets nothing until next time. That’s why you’ll often see a slight dip in valuation right around dividends are paid out, as assets are transferred out of the company thus decreasing its value a little to new buyers. Existing owners, of course, are compensated for the price dip through hard, cold cash.

Lastly, there is the distribution date – which is simply when the checks are mailed out and money deposited into bank accounts. This can be several weeks after the record date. Stocks held in mutual funds are a little different but work essentially the same way.

Many choose to issue end-of-year dividends as a “mop-up” effort, but the basic idea of distributing money to the stockholders hold true. Some companies issue stock instead of cash. These stock dividends simply increase the number of shares you own, so that instead of having 500 shares of company X, you now have 520 shares, which can be sold and traded like any other stock position.

Many others, especially growing companies, choose to forgo dividends altogether. These are typically young, growing companies where the money is better spent facilitating growth and expansion. Mature companies are less nimble and tend to settle into their comfy roles as cash cows and are happy to share their profits with investors.

The former tend to be riskier – along with a higher chance of big payoff – while the latter is often a safer option. Neither approach is wrong and dividends alone are no indication of whether a company is about to hit it big, but it’s definitely a piece of the puzzle.

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