What are dividends?
Dividend stocks come from companies that reward shareholders with regular payments throughout the year. Typically, this cash is tied to the company’s profits but it can also come from their reserves. Many dividends are paid quarterly as cash, but there is also a number that reinvest dividends into more stocks for their shareholders.
How do dividends affect a company’s stock price and overall value?
Dividends can have an impact on the underlying stock value, and this can happen in a number of different ways. Before a dividend is distributed by a company, the board of directors must declare the date and the amount. There’s also a buy deadline date. Naturally, such an announcement pulls investors into purchasing stocks, which drives the price of stock upwards. When the ex-date arrives, investors drive the stock price down, which accounts for new investors being illegible for the dividend.
What is the dividend yield?
A dividend yield refers to the amount that a dividend pays across the year. Each dividend yield is displayed as a percentage (dividend/price). This figure is an estimation of what the dividend-only return will be. In the majority of cases, when the stock price falls, the dividend yield will increase. The dividend yield can seem confusingly high, especially when the price of a stock plummets fast.
Dividend yields will look different depending on the size of the company as well. For example, a new company may pay a lower dividend than well-established companies. Typically, the largest yields will be with mature companies. When it comes to sectors, utilities and other market stables are a safe bet.
What are the advantages and disadvantages of investing in dividend-paying stocks?
The most obvious benefit of dividend investing is the prospect of regular income, which is great when investors are trying to grow their portfolios in alternative ways. Another advantage to investing in dividends is safeguarding against the stock market movement, which can be volatile at times. To the individual investor, having this protection is valuable because they don’t have access to the same tools as institutional investors.
Despite the advantages of dividend stock investing, there are reasonable disadvantages as well. For example, dividend stocks will likely have a cap on the amount of annual interest they’ll pay out. In today’s market, this is likely to be around 10%. Additionally, many investors fall into the high-yield dividend trap, which can lead to significant losses because of a quickly reduced yield.
How do companies decide how much to pay in dividends to their shareholders?
A company’s board of directors is usually responsible for deciding how much dividend to pay. After making the decision, a company has three dividend-paying methods:
- Stable. These dividend-paying companies are consistent, regardless of profit fluctuations.
- Residual. This policy means a company is reliant on leftover equity, which means it can be more flexible.
- Hybrid. The hybrid method is popular, as it accounts for cycle variations. Typically, a low baseline dividend is set and extra dividends can be announced.
What is a dividend reinvestment plan (DRIP) and how does it work for investors?
DRIP dividend plans are when the company reinvests the dividend in more shares. Even though this doesn’t reward a cash income, it can hold value for an investor. For example, their investment pool grows, and they don’t need to pay any additional commissions. This is particularly useful during periods of wide commission increases.
Dividend investing can be a huge relief during market volatility, but the stable income doesn’t compare to the returns on a willingness to face risk.