What is a stock dividend? A profitable company might pass along a portion of its earnings to its shareholders in the form of a dividend. This payment can consist of either cash or additional stock shares. Companies might offer stock instead of cash dividends if they are short on liquid assets. Some companies pay dividends with property, which can include any item that has a tangible market value, from gold and silver to everyday household wares.

When a company issues both preferred and common stock shares, dividends must be paid out to preferred stockholders before they are paid to holders of common stock.

How Do Dividends Work?

Most companies meet with the board of directors each quarter to finalize the financial statement for that three-month period. If the board and leadership decide to provide shareholder dividends, they will notify the recipients of the payout date and amount. This information will also be put in a press release that is sent to the major stock sharing services.

The amount of a stock dividend is expressed as a percentage of the person’s existing shares; for example, the dividend could be 0.05 shares per existing share owned. This arrangement is similar to a stock split because even though each investor who qualifies will increase the number of shares they own, the total market value of those shares will remain the same. This effectively lowers the per share price of the stock, which often benefits the company by increasing the trading volume.

When a company issues a stock dividend, it must make a journal entry transferring its value from retained earnings to paid-in capital. The amount of the transfer depends on whether a small or large dividend has been issued. A small dividend equals less than a quarter of the total value of outstanding shares and is transferred at the market value. Large dividends consist of more than a quarter of outstanding shares and are transferred based on their par value.

Prior to the payment date, the company places the disbursement funds with the Depository Trust Company (DTC). This company disburses funds to the brokerages through which the shareholders trade. The brokerages will either pay out cash dividends or repurchase new investments depending on your instructions.

How Are Dividend Payments Taxed?

Both stock shares and cash dividends constitute taxable income. Specific tax treatment varies based on the shareholder’s history with the company, the type of account in which he or she holds the shares, and the type of dividend in question. You will receive a Form 1099-DIV at tax time that will be filed along with your income tax return for the year in which you received the dividend. In general, dividends paid in stock are not taxed until the investor sells those shares to someone else.

The tax rate for dividends tends to be less than the tax rate for normal income as long as the investor holds on to his or her shares for 60 days. Qualified dividends are subject to the capital gains tax rate. Lawmakers frequently argue about the benefits and drawbacks of the lower tax rate for dividends.

When Are Dividends Paid?

Most companies issue dividends four times a year. The day on which the company’s board announces the dividend payment is the declaration date. The record date is the date by which shareholders must be on the books with the company to receive the dividend in question.

Typically, companies will mail shareholders a check or stock certificate within several days of the date when the stock starts trading without the dividend. This is known as the ex-dividend date.

In addition to standard quarterly dividends, companies will occasionally offer special one-time dividends. These payments often result from investment liquidation, sale of the business or a portion of the business, or a significant victory in court. Like other types of dividends, they can take the form of property, cash, or stock shares.

In general, companies only pay dividends when they cannot reinvest profits at a higher rate than the shareholders would earn on the market. For example, if a company earns 25% on its equity shares, it should reinvest that money in the company rather than distribute it to shareholders who would receive a lower return.

What Is a Dividend Payout Ratio?

A dividend payout ratio is the percentage of the company’s net income that shareholders receive as a dividend. This ratio helps determine how much the company will likely grow, especially when looking at the retention ratio (the amount the company reinvests into the business rather than paying to shareholders).

Let’s look at an example. Coca-Cola reported that shareholders received $2.166 billion in dividends in 2003 with a net income of $4.347 billion. To find the dividend payout ratio, divide $2.166 billion by $4.347 billion, which equals almost 50%.

The investor can also calculate the dividend yield, which shows how much he or she is currently earning based solely on the stock’s market price. To find this number, divide the annual dividend by the share price.

What Are Dividend Reinvestment Plans?

Investors can derive many benefits from this type of plan, which is often called a DRIP. You can use these funds to add dividend payments to your equity holdings without the complication of purchasing more shares with cash. These transactions rarely have commission fees when they are operated by the company rather than by a broker. This is ideal for small investors who are subject to significant commission fees even on small purchases.

When you are part of a dividend reinvestment plan, your company might discount shares for stockholders who pay in cash. Often, this discount is as high as 10%. This allows you to obtain more value for your money compared to buying shares directly from a brokerage.

Once you have enrolled, which usually only takes a few minutes, your dividends will be reinvested in the plan automatically, and you don’t have to make any further decisions. You can even arrange automatic debit or credit card payments to buy more shares of stock regularly or on a one-time basis, often at low or no commission.

This type of plan also allows you to buy fractional shares, which can exponentially increase your investment over the long-term. You can choose to invest some of your shares in a DRIP and receive the remainder in cash dividends.

How Can Investors Successfully Choose High Dividend Companies?

If you want to earn significant dividends on your investment portfolio, you should look closely at the company’s history when it comes to paying shareholder dividends. Make sure the company has paid dividends that have increased in value steadily over at least the past two decades and that it still has the cash flow to keep up this track record in the coming decades.

Remember to look at cash flow, not reported earnings, when determining whether you think a company can afford to pay dividends. This appeals to the type of investors who prize stability. Conversely, a company will probably see a stock price decline if it lowers its dividend payout. Most companies do not increase the dividend until they can afford to do so consistently.

Companies that do not pay dividends often cannot afford to do so. Check the business’s 10K document, which is filed with the U.S. Securities and Exchange Commission, to find out whether it’s tied up with credit lines, bank loans, and other forms of debt.

Large, well-established companies are more likely to pay regular dividends than smaller companies. Industries in which dividend payments are most common include utilities, pharmaceuticals, health care, finance and banking, gas, oil, and basic materials, as well as all real estate investment trust and master limited partnerships. These business structures require regular shareholder dividends in a specific amount.

If you’re new to investing, check out Raging Bull for expert advice on the stock market. You can sign up for a free e-book, hosted webinars, up-to-the-minute news, and much more.

Author: Jeff Bishop

One of the best traders anywhere, over the past 20 years Jeff’s made multi-millions trading stocks, ETFs, and options. He is renowned as an incredible trader with a deep insight and a sensitive pulse on the markets and the economy. Jeff Bishop is CEO and Co-Founder of RagingBull.com.

Even greater than his prowess as a trader is his skill and passion in teaching others how to trade and rake in profits while managing risk.

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