What is a Dividend Stock?

January 17, 2023
for People

If you've read or watched any financial news lately, you've likely heard the words "dividend stock". What exactly is this unknown stock that regularly shares profits with its shareholders? Do some companies pay their investors to own their stock?

In this article, we will cover the following topics:

- What is a dividend stock?

- What type of companies are labeled as dividend stocks?

- How are dividends calculated?

- How are dividends paid?

- What are the downsides of investing in dividend stocks?

- Why do companies pay dividends?

What is a dividend stock?

A dividend stock is a type of stock that pays out a portion of the company's profits to shareholders on a regular basis. Think of it like a present that a company gives to its owners (the shareholders) for investing in the company.

When a company makes money, they can choose to keep it all to themselves, or they can share some of it with their shareholders in the form of dividends. Dividend payments are usually made quarterly (every three months) or annually (once a year).

For example, let's say you own 100 shares of a company that pays a $1 dividend per share annually. If the company pays out dividends, you would receive $100 ($1 x 100 shares) in dividends from that company each year.

What type of companies are labeled as dividend stocks?

As briefly described above, the type of companies that pay dividends are well-established companies that make a profit. Some examples are companies that are in the industrial, consumer defensive, and consumer cyclical sectors. For example, 3M (NYSE:MMM), Procter & Gamble (NYSE:PG), and Home Depot (NYSE:HD) all pay dividends to their shareholders.

You'll notice a common these between these companies, which is they may be less exciting that the latest technology or biotechnology companies. However, investors choose to invest in dividend stocks because of the income and stability rather than the high returns. 

To further break down what type of companies pay dividends, let's look at low yield, moderate yield, and high yield dividend stocks.

infographic with title "dividend stocks: 3 types of dividends"

How are dividends calculated?

With the different type of yields, you may be wondering, "how do companies choose how much their dividend will be?"

A company decides how much to pay based on its individual dividend policy, which is created by the company's board of directors. The board will take the long-term earnings forecasts into consideration when deciding what percentage of its earning it wants to pay in the form of a dividend. Oftentimes, there is a target payout ratio that is decided upon, which is a percentage of the company's earnings that will be paid out to shareholders over a certain time horizon. The board of directors then submits the dividend policy with a filing through the Securities and Exchange Commission or a press release. 

What are the important things you should know about dividends?

Announcement date: when the company officially announces the dividend plans

Payment date: when an investor will receive the dividend

Record date: when investors are recorded as shareholders to receive the dividend

Ex-dividend day: when shareholders will no longer receive the next dividend

How are dividends paid?

If you own a dividend stock and are considered a shareholder by the record date, then you will receive the dividend on the determined payment date.

When the divided is paid out, the money will automatically be deposited in your account. Some brokerages allow automatic reinvestments of dividends , or you can decide to keep it as a cash balance. Dividends are often paid quarterly. 

What are the downsides of investing in dividend stocks?

If you invest in a company that pays dividends, you must remember that they are not guaranteed. In some cases, company's may be forced to reduce or eliminate dividend payments due to the financial performance of the company. 

Dividends are not tax free when an investor owns the company in a taxable account. Dividends may be taxed as ordinary of qualified, so you should be sure to ask your financial advisor or accountant for advice. You can browse these financial professionals on our marketplace here.

Note: when a company is considered a high-yield dividend paying company, this may indicate that the company is generating sufficient profits, but may not have future projects to invest in. If company's do not have future projects to invest in, their ability to generate better returns in the future can be questioned.

There are typical downsides of any investment as they are exposed to many different types of risk.

Why do companies pay dividends?

Company's pay dividends for many reasons, but one of the most common reasons is shareholders want to be rewarded for their investment. Company's look at dividend payments as a means to maintain the trust of their investors, as well to share its financial strength.

In Summary

A dividend stock is a type of stock where a company pays out a portion of its profits to shareholders on a regular basis, like a present. The payments are usually made quarterly or annually. Some companies pay dividends, while others don't. Dividends are not guaranteed and depend on the company's earnings.

Investing in dividend stocks can be part of an investors overall investment strategy, but should be discussed with a licensed and regulated financial advisor like the ones found on AdvisorFinder. Dividends can help generate income and can be reinvested to boost your overall total return, which is why many investors are interested in them.