What Is a Dividend and Why Do Companies Pay Them? | Nemo Money

When you start investing in the stock market, you’ll probably come across the term dividend pretty early on. It gets thrown around a lot in investing circles, but if you’re not 100% sure what it actually means, you’re not alone.

So, what is a dividend? And why do companies pay them out in the first place? Let’s break it all down in plain English.

Key Points

‍What is a dividend? A portion of a company's profits paid out to its shareholders.

‍How often are they paid? Dividends are paid typically quarterly, but sometimes annually or monthly.

‍Who gets them? Anyone who owns shares of a dividend-paying stock or ETF on the record date.

‍Why do companies pay them? To reward shareholders, signal financial health, and attract investors.

First Things First: What Is a Dividend?

In the simplest terms, a dividend is a payment some companies make to their shareholders (a.k.a. people who own shares in the company). It’s usually a portion of the company’s profits that gets handed out as a little “thank you” for investing in them.

Think of it like this:

• You buy a slice of a company (a share).
• The company makes a profit.
• The company decides to share some of that profit with its shareholders.
• You get a payment — that’s your dividend.

Dividends are usually paid out in cash, but sometimes they come in the form of additional shares. They’re typically distributed every quarter (every three months), but some companies pay them monthly, annually, or on a special one-off basis. 

Dividend Meaning: What is a Dividend in Simple Terms

Let's translate the finance speak into something a bit tastier, like pizza!

• Dividend: Imagine a pizza place that’s really successful. A dividend is like the owner deciding to share some of that success with you, their loyal customer, by giving you a free slice of pizza just for being there.
• Dividend stock: If you own stock in a company that pays dividends, then you are like a regular at the pizza restaurant that regularly gives out those free slices to their customers.
• Dividend yield: This tells you how big of a slice you're getting compared to the whole pizza you bought. A bigger slice for your money is a higher yield!
• Dividend per share (DPS): This is the exact size of that free slice you get for each whole pizza (share) you own.

H2: Types of Dividends

While cash dividends are the most common, companies can pay out profits in a few different ways. Here's a quick look at the main types:

• Cash Dividends: This is the most common type, where companies pay out a portion of their profits directly to you in cash. It's like receiving money straight into your investment account.
• Stock Dividends: Instead of cash, the company pays you in additional shares of its own stock. This increases the number of shares you own, though it doesn't immediately put cash in your pocket.
• Special Dividends: These are one-time, non-recurring dividend payments that a company might issue if it has an exceptionally profitable period or sells off a major asset. Think of it as an unexpected bonus slice of pizza!
• Preferred vs. Common Dividends: Some companies issue different types of shares. Holders of "preferred shares" usually get a fixed dividend payment that is paid before "common share" holders receive anything, but common shareholders typically have voting rights.

H2: Advantages and Disadvantages of Dividends

While dividends can be a fantastic part of your investment strategy, it's good to understand both their upsides and potential downsides.

Advantages of Dividends:

• Predictable Income Stream: Dividends can provide a regular, often quarterly, cash income directly to your account, which can be useful for living expenses or reinvestment.
• Lower Volatility: Dividend stocks, especially those with a long history of payments, are often from more established companies and may experience less price swings compared to fast-growing, non-dividend stocks.
• Compounding Power: Reinvesting dividends allows you to buy more shares, creating a snowball effect where future dividends are even larger, accelerating your wealth growth over time.
• Signal of Financial Health: Consistent dividend payments can signal that a company is financially stable and has strong, predictable earnings.
• Potential for Total Return: Dividends contribute to your "total return," which includes both the capital appreciation of your shares and the income from dividends.

Disadvantages of Dividends:

• Not Guaranteed: Dividends are not guaranteed and can be cut, reduced, or suspended by companies, especially during tough economic times.
• Taxable Income: In many regions, the cash dividends you receive are considered taxable income, which can reduce your net return unless held in a tax-advantaged account.
• May Reduce Reinvestment Capital: Companies that pay high dividends might be reinvesting less of their profits back into the business, which could potentially slow their future growth compared to companies that prioritize reinvestment.
• "Dividend Traps": Some companies might offer a very high dividend yield that seems attractive, but it could be a sign of underlying financial problems that might lead to a dividend cut or stock price decline.
• Focus on Income Over Growth: A strong focus on dividends might lead investors to overlook companies with high growth potential that do not yet pay dividends, potentially missing out on higher capital appreciation.

‍How Do Dividend Payments Get Into My Account?

Okay, so a company decides to pay a dividend. Great news! But how does that actual cash end up in your bank account? Here's the basic rundown:

• The Company Decides: The company's board of directors will meet and decide if they want to pay a dividend, how much it will be per share, and the important dates.
• The Ex-Dividend Date: This is a crucial date! If you want to receive the upcoming dividend, you need to own the shares before the ex-dividend date. If you buy on or after this date, you won't get the next payout.
• The Record Date: This is the date the company checks its records to see who the official shareholders are. If your name is on the list by this date, you're eligible for the dividend.
• The Payment Date: This is the day the money actually lands in your account! You can transfer money from your brokerage account to your bank account.

Companies can pay your dividends in a few different ways, here are some examples:

Cash (The Most Common Method): This is the way most investors receive their dividends. The company simply sends a cash payment for the amount of the dividend multiplied by the number of shares you own. This cash is usually deposited directly into your brokerage account (with Nemo Money for example.)

Reinvestment (Dividend Reinvestment Plans - DRIPs): Some companies offer Dividend Reinvestment Plans (DRIPs). Instead of receiving a cash payment, your dividend is automatically used to purchase more shares of the company's stock. This can be a great way to compound your returns over time, as you'll own more shares that can potentially pay future dividends.

Stock Dividends: Less commonly, a company might issue a stock dividend. Instead of cash, you receive additional shares of the company's stock proportional to your current holdings. For example, a 5% stock dividend would mean you receive 5 new shares for every 100 shares you already own. While you don't get cash directly, you now own more of the company.

How Does the Dividend Yield Formula Work?

The dividend yield formula is a quick way to figure out how much you’re earning from your investment in dividend terms.

Here’s the formula:

Dividend Yield = (Annual Dividend per Share / Share Price) x 100

Let’s break that down with an example:

• A company pays out £1 in dividends per share over the course of a year.
• The current share price is £20.

Dividend Yield = (£1 / £20) x 100 = 5%

So, if you owned that stock, you'd be earning a 5% return just from dividends — not counting any increase in the share price itself. Nice!

Why Do Companies Pay Dividends?

Now for the big question: why would a company want to give away some of its hard-earned profits? It might seem counterintuitive at first, but there are actually some pretty compelling reasons:

• Sharing the Spoils (and Keeping Investors Happy): One of the most straightforward reasons is to reward their shareholders. By paying dividends, companies are essentially saying, "Hey, we're doing well, and we want to share our success with you for believing in us!" This can keep existing investors happy and loyal.
• Attracting New Investors: Dividend stocks can be a real magnet for certain types of investors, particularly those looking for a regular income stream. Think of retirees or those building a more conservative portfolio. A company with a history of consistent dividend payments can look very attractive compared to one that doesn't offer any payouts.
• Signaling Financial Stability and Maturity: Companies that consistently pay dividends are often seen as more financially stable and mature. It suggests they have a solid track record of profitability and are confident in their future earnings. This can boost investor confidence and even the company's stock price.
• Using Up Excess Cash: Sometimes, a company might have more cash on hand than it needs for immediate reinvestment or growth opportunities. Instead of letting that cash sit idle, they can choose to distribute it to shareholders through dividends.
• Discipline for Management: The pressure to maintain or even increase dividend payments can act as a discipline for company management. They need to ensure the company remains profitable enough to continue rewarding shareholders.

Dividends Aren't Guaranteed (The Small Print!)

While dividends can be a fantastic way to generate income from your investments, it's crucial to remember that they are not guaranteed. Companies can choose to reduce or even eliminate their dividend payments if their financial situation changes. This can happen during economic downturns or if the company needs to reinvest its profits for future growth or to overcome challenges.

Therefore, it's always important to do your research and not rely solely on dividends when making investment decisions. Consider the company's overall financial health, its history of dividend payments and its future prospects.

Nemo Money: Helping You Navigate the World of Dividends

At Nemo Money, we want to make understanding and accessing dividend-paying stocks as easy as possible. Our app and website will clearly show you information about potential dividends, including the dividend yield and important dates, so you can make informed decisions about your investments.

Ready to earn dividends? Open a Nemo.Money account and start investing in dividend stocks today. Download the Nemo.Money app and claim your bonus! New Nemo.Money users can grab our registration bonus up to a maximum of $50 on first deposit. Terms and conditions&terms of use apply.

FAQs

‍How much does it take to make $1,000 a month in dividends?

It really depends on what you're investing in and its dividend yield (how much it pays out relative to its price). To get $1,000 a month (that's $12,000 a year), you'd generally need a pretty hefty investment. For example, if your investments pay a 4% dividend, you'd need about $300,000 invested. But if you find something with a higher yield, you might need less – say, around $100,000 to $150,000 for a 10% yield – just remember higher yields usually come with higher risks!

Are dividends good or bad?

Dividends are just one of many  ways your investments can pay you back. They're awesome if you want regular income or love seeing your money compound, but sometimes companies that pay big dividends might not be growing as fast because they're sending cash to shareholders instead of reinvesting it all. It really boils down to your personal goals!

How can I earn dividends?

It's pretty simple! You just need to own shares in a company's stock or an ETF that pays dividends. If you own them by a certain date (the "record date"), you'll get your payout.

Are dividends guaranteed?

Nope, dividends are not guaranteed. Companies can cut, reduce, or even stop paying dividends if their profits drop or they decide to use that cash for other things. So, while a company might have a long history of paying, it's never set in stone.

What’s the difference between dividends & interest?

Think of it this way: dividends are like a "thank you" slice of profit you get for owning a piece of a company, they're not promised. Interest, on the other hand, is what you get paid for lending money, like from a savings account or a bond. Dividends are optional while interest is not.