Outline:

  • A dividend is a distribution of a company's profits;
  • It is proportional to how many shares you own in that company.
  • Not all companies issue dividends, but some do.

A company can decide to thank shareholders for their support through a dividend payment, usually straight up cash.

These payments are usually a fraction of that shareholder owns.

Say Facebook makes a profit and you own shares in Facebook. If Facebook were to pay a dividend (not saying that they do), you would be entitled to a certain percentage of the profit that the company distributes to their shareholders.

The amount you are entitled to is determined by how many shares of Facebook you own and what share class you own. Investors call this pro-rata, which means proportional.

For example, for every share you own you might receive 25 cents. Or $1. Or $100. It's really up to the company.

Your share of dividends is proportional to how many shares you own.

As we hinted at above, dividends can come in various forms and you can expect to earn a dividend up to four times a year, at the end of each quarter.

What you do with your dividends is up to you. You may choose to reinvest your dividends back into the stock that issued them, or into the market as a whole.

You could cash out and keep them as profit if you wanted to.

Why do people reinvest their dividends?

The main reason people reinvest their dividends, rather than spending the cash on a holiday, is the same reason we all invest. Over time that little amount of money can grow into a lot more.

Compounding interest takes time and you are forgoing additional income but if you're able to, it can be valuable over the long term.

It's a decision you have to make as an investor. Do you want to reinvest your dividends? Or take the additional income from your investments and use it for something else?

Like all investing, it's about balancing how much income you need to live, how much you need to invest for later, and your risk tolerance.

What type of companies issue dividends?

Dividends are usually issued by larger companies who feel comfortable distributing their earnings to shareholders, rather than using the money to fuel more growth.

If you're invested in startups and other high-growth companies, like many in the technology sector, you may not receive dividends as much as people who are investing in banking stocks.

High-growth companies and their investors are often comfortable posting losses in their early years in order to use all revenue to fuel a high-growth rate.

One of the more famous examples of this is Amazon. Until recently, the company had basically never earned a profit, despite being one of the world's most valuable companies. If you look at Amazon's stock price it has gone up, and up, and up, (though not without a few bumps along the road).

The reason is Jeff Bezos is using any profits he gets to continue to grow Amazon and its other businesses. If you're investing in Amazon, one thing to think about is will this growth rate continue, and will the market continue to value growth over profits?

Another way to think about it is, do you think Bezos can earn a better return on your investment than you can? What we mean by this is if you got the dividend from Amazon, rather than them reinvesting it back into the business, would you be better off? We can't answer that but it's something to think about.

This approach usually only works if investors know what they're getting into.

If a company issues dividends year-on-year-on-year, then one day decides to stop issuing dividends to reinvest for growth, it may signal to the market that what they were doing was wrong. This could hurt the share price.

What is the dividend yield?

The dividend yield is a ratio: the ratio of cash dividends relative to a stock's price. You can think of it as a measure of how much you get back for what you put in.

Say you own 1,000 shares of fictional company Alphazon and it pays a five cent dividend per share each quarter.

You will get $50 (number of shares X dividend per share) in dividend income four times a year.

The share price for Alphazon is $100 each, so you have $100,000 invested. You can calculate the dividend yield of Alphazon by dividing the dollar value of the dividends paid in a year (per stock) by the price of one share.

Annual share dividend = $0.20

Price per share = $100

Dividend yield = $0.20/$100

Dividend yield = 0.2%

Keep in mind that most people will use the previous year's dividend payments to estimate yields. This is because there is no clear way to determine what a dividend will be in the future.

What this means is there is no clear way to know the dividend yield before dividends are issued, as it is directly affected by the price of the stock and dividends. Both of which can change.

Past performance is no guarantee of future performance, but understanding how to use historical price and dividend data can give you an idea of what to expect, as long as no black swans occur.