What are stock dividends and how do they work? (2024)

Stocks that pay dividends are a major component of any well-constructed, long-term portfolio. That’s because dividends drastically increase a stock’s total return — your true rate of return including income and capital appreciation — over time and provide cushion when stocks decline.

Of course, any stock that pays a dividend is a dividend stock. But not all dividend stocks are the same. To get started investing in dividend stocks, it’s important to understand exactly what a dividend is and the difference between the main types of dividend stocks.

By the end of this guide, you’ll know the difference. And you’ll walk away with the knowledge you need to incorporate dividend stocks into your own portfolio and generate income that can help grow your nest egg.

What are stock dividends?

Stock dividends are payments a company makes from its overall profits to shareholders as a reward for their investment. Dividends are most commonly paid to shareholders as cash dividends but are occasionally paid out as additional shares of stock.

In order to be eligible to receive a company’s dividend payment, a shareholder must purchase or own the stock prior to the company’s ex-dividend date. Because dividends are paid out of a company’s profits to shareholders, the ex-dividend date is when the stock begins trading without the value of those profits factored into its share price. As a result, a dividend stock’s share price typically drops by the amount of the dividend payment on the ex-dividend date.

As long as you own shares of the stock before the ex-dividend date and on the record date, which is usually the day after the ex-dividend date when the company “records” its list of eligible shareholders, the dividend is distributed directly to your account on the payment date.

How stock dividends are calculated

Dividend yield is a ratio that measures the annual dividends a company pays relative to its stock price. Dividend yield provides a good sense of how much dividend income you can expect for every share of a dividend stock you own. Yields can vary widely from company to company, so to get a baseline comparison, look at the average dividend yield of the S&P 500, which was 1.57% as of September 30, 2023.

To calculate dividend yield, simply divide a company’s annual dividend by the current price of its stock.

Annual dividend ÷ Stock price = Dividend yield

Here’s a hypothetical example:

A company pays a $1 annual dividend. Its current stock price is $50. Using the formula above, the math looks like this:

$1 ÷ $50 = 0.02

To get the percentage, move the decimal point over two places to the right. So the dividend yield in this example is 2%.

Most platforms that provide detailed stock quotes take care of this math, putting metrics such as annual dividend payment and dividend yield right in front of you.

In actual dollar amounts, if you own 100 shares of a stock with a $1 annual dividend, you’ll receive — all else being equal — $100 of annual dividend income. If the stock you own trades for $50, you have a position size worth $5,000. As we established, this translates to a 2% dividend yield. And, of course, 2% of $5,000 equals $100.

Risks of investing in dividend stocks

Some of the best-paying dividend stocks pay relatively high yields. But being among the highest dividend stocks based on yield alone doesn’t make a dividend stock a good investment. In fact, sometimes a high yield can be a red flag.

Because dividend yield is a function of stock price, an alluringly high dividend yield can be a red flag. As the stock price goes down, dividend yield goes up, assuming the dividend payment holds constant.

Let’s go back to the example of a $50 stock paying a $1 annual dividend for a yield of 2%. Cut the stock price in half — to $25 — and suddenly that stock yields 4%, even though the dividend payment has not changed.

It doesn’t take a finance degree to figure out that a stock that loses half its value is not a good thing, and likely indicates problems at a company. Naturally, it follows that a dividend yield that increases quickly or seems too good to be true often is — not always, but often.

So, beware of high and seemingly attractive, but potentially dangerous, dividend yields. They’re known as yield traps.

Remember, just because a company pays a dividend today doesn’t mean it will pay one forever — or even tomorrow. Sometimes companies reduce, rather than grow, their dividends or eliminate them altogether. This underscores the importance of buying high-quality dividend stocks from companies with strong performance records and bright prospects.

From an investment perspective, focusing too much on dividend stocks can take other opportunities off of your radar. Stocks that don’t pay dividends sometimes provide superior returns on stock price appreciation alone than even the best dividend stocks do on total return.

How do dividend payments work?

Companies typically pay dividends quarterly. A company that pays a $0.25 quarterly dividend has a $1 annual dividend.

Less common, some companies pay dividends monthly. Realty Income Corp. (O) is the most well-known company on this schedule. It is a self-proclaimed monthly dividend company.

Even less common, companies occasionally pay special, one-time dividends. Usually much larger than a company’s regular dividend, a one-time dividend tends to result from a period of strong profitability or excess cash reserves. Costco Wholesale Corp. (COST) is well-known for issuing one-time dividends, having done so in 2012, 2015, 2017 and 2020.

You can choose to receive dividend payments in cash, or straight into your investment or bank account. Or, you can opt to reinvest dividend payments into new shares of stock. This is a core strategy for many dividend-growth investors.

Reinvesting dividends for growth

Investors often use dividends to generate income. Let’s say you earned $100 in dividend income from a stock. You can take that $100 in cash and save or spend it. However, this isn’t enough money to supplement most people’s incomes or lifestyles over the long haul. Therefore, many dividend-growth investors reinvest dividends.

By purchasing additional shares of stock with your dividend payment, you grow your position size and — as long as the company’s dividend payment remains constant or, better yet, grows — you gradually increase the amount of the quarterly (or monthly) dividend payments you receive. Over time, you can realize a compounding effect that can grow your nest egg and portfolio income.

Some investors opt for DRIPs, or dividend reinvestment plans, offered directly by the company paying the dividend or facilitated by third parties, such as Computershare, which offer DRIPs as part of Direct Stock Purchase Plans.

Sometimes, investors use yield to estimate how much income they’ll receive from an individual stock or dividend stock portfolio.

Here again, we take the earlier math on dividend yield and turn it around. If you own 100 shares of a $50 stock that yields 2%, you can expect to receive $100 in annual dividend income. If you have a goal of generating $10,000 in annual dividend income from that $50 stock, you would need to own $500,000 worth, or 10,000 shares, of that $50 stock.

You can run the same math on a portfolio of dividend-paying stocks by taking the average weighted yield across your holdings and multiplying it by the value of your dividend stock portfolio.

The big takeaway? While you can generate meaningful income from dividend stocks, beware of people who claim it’s easy to produce passive dividend income to cover part or all of your life expenses. It takes time and a healthy-sized nest egg to arrive at this point.

High-yield mutual funds and ETFs

On one hand, investing in dividend stocks is straightforward. You buy dividend stocks the same way you add non-dividend stocks to your portfolio, typically through your brokerage account, with the added question: Would you like to reinvest the dividend payments?

On the other hand, finding a solid slate of individual dividend stocks isn’t quite as straightforward; it requires considerable research.

You can also purchase mutual funds or exchange-traded funds (ETFs) that only own dividend stocks. These funds own dividend stocks around myriad themes, including geographic region and investment style. Most attempt to mimic the returns of broad, but dividend-specific, stock market indices. Entire mutual fund and ETF families focus on dividend-growth stocks, such as dividend aristocrats and similar categories.

When you invest in dividend funds, you typically receive dividend payments at regular intervals from the fund after it receives dividend payments from the companies in its portfolio.

Tax implications of stock dividends

From a tax standpoint, there are two main types of dividends: qualified and ordinary. The classifications can get complicated, so check with your tax advisor for specifics. But, generally speaking, most long-term, buy-and-hold investors collect qualified dividends. The IRS taxes these dividends at 0%, 15% or 20%, depending on your income. The IRS taxes ordinary dividends at income tax rates.

Tips for investing in dividend stocks

To find the best dividend-paying stocks, focus on two primary classifications:

• Dividend-growth stocks.
• High-yield dividend stocks.

Dividend-growth stocks

The word “growth” in dividend-growth stocks doesn’t refer to the revenue or profits of a company. While sales and earnings growth are important factors to consider when searching for top dividend stocks, growth, in this context, refers to a company’s dividend payment growing over time.

Often, the best dividend stocks have a track record of increasing their dividend payments. For example, a company that started paying a $0.50 annual dividend in 2000 and increased that payment by an average of 2% every year — bringing their dividend to $0.79 in 2023 — is a dividend-growth stock.

Dividend-growth investors almost always consider the number of years in a row a company has increased its dividend payment. For example, investors refer to companies that have increased their annual dividend payment for at least 25 consecutive years as dividend aristocrats.

While it’s true that most companies reevaluate and increase their dividends annually and continue paying dividends even when the broad market declines, don’t assume all dividends are safe or will annually increase. Some companies, during times of trouble or periods of transition, halt dividend increases or, worse, reduce or eliminate their dividend altogether. This can happen at any time but was exacerbated by the COVID-19 pandemic.

For example, Disney (DIS) suspended its dividend in the first half of 2020 after having paid one for 37 consecutive years. As of August 2023, the company said it intends to declare a dividend by the end of 2023, which would make it payable in 2024.

High-yield dividend stocks

Some of the best-paying dividend stocks pay relatively high yields. But being among the highest dividend stocks based on yield alone doesn’t make a dividend stock a good investment. In fact, sometimes a high yield can be a red flag.

Dividend yield is a ratio that measures the annual dividends a company pays relative to its stock price. Dividend yield provides a good sense of how much dividend income you can expect for every share of a dividend stock you own. Yields can vary widely from company to company, so to get a baseline comparison, look at the average dividend yield of the S&P 500, which was 1.57% as of September 30, 2023.