What Is A Dividend?

I was asked recently by a co-worker, “what is a dividend?” after having a brief discussion on investing and the like. I had never really thought that this was unknown knowledge to certain people. I take for granted, in my studios nature of observing investments, that the term “dividend” is well known and generally fairly obvious. I was proven today that my thinking was incorrect and naive. I would like to try to explain today what exactly a dividend is.

Per Investopedia, a dividend is:

A distribution of a portion of a company’s earnings, decided by the board of directors, to a class of its shareholders. The dividend is most often quoted in terms of the dollar amount each share receives (dividends per share). It can also be quoted in terms of a percent of the current market price, referred to as dividend yield.

This is a fair summation of what exactly a dividend is. The distribution of earnings, which can be in the form of money, shares or even property, is a method in which the company tries to reward the shareholder for investing in the company. It is primarily because of this distribution that I invest in dividend growth stocks. I want to know that the company is healthy and producing profits. I can look at balance sheets all day long, but the best way to know a company is healthy and actually has cash is when they return some of that money directly to me. It’s the “proof in the pudding” as one would say. 
Not all companies return a portion of earnings back to shareholders. Most growth companies, which are defined as any company that is growing faster than the relative market, do not pay a dividend. That is because the growth company usually would rather reinvest the earnings back into the business (retained earnings) to keep the growth rate high. This could be perceived as a positive or a negative, depending on your point of view. For some, they like that the company has better ideas and perhaps the company can grow that money at a better rate than the investor. Also, this saves on taxes, so as to avoid double taxation (at the corporate level on earnings, and again on the dividend paid to the investor).
For me, I prefer not to invest in growth companies. First, there is no guarantee that the company can actually get a better rate of return on the money than I can. Second, I like to reinvest the dividends and therefore compound my investment. I can’t reinvest capital when I’m not receiving any from the company I’m investing in. There are cons to receiving dividends in lieu of the company retaining the earnings. I get taxed on the dividend, which is currently at a 15% federal tax rate. That means only 85% of those earnings are hitting my wallet. Some view this double taxation as unfair and a natural disadvantage to dividend investing. Also, there is perhaps the chance that I won’t grow that money as fast as the company can. 
I view receiving dividends as a positive, however, because it gives me freedom of choice in how to reinvest that returned capital. Perhaps reinvesting the dividend back into the company that paid it is the prudent choice, because that company is undervalued. Perhaps, sitting on cash due to an inflated market is the best move. Or, I could be at the age where I’m living off my dividend income and I’m trying to pay bills and meet expenses. No matter the situation, with the distribution of a portion of earnings in my hand, I can choose how to use it. I think that’s just fantastic.
Thanks for reading.

Comments

  1. says

    I love simple posts such as this one! I too prefer companies that payout dividends. Some companies don’t pay out dividends since they believe they can better manage the money than giving it back to shareholders.

    I’d like to be the judge of that! :)

  2. says

    Good tutorial. I’m consistently surprised at people I encounter that lack knowledge on finance. Even engineers I meet often aren’t particularly knowledgeable about areas of finance including dividends.

    The very first article on my blog was also called What is a Dividend, since I wanted to put down a foundation for it right away on my site.

  3. says

    Dividend Monk,

    Thanks for stopping by. I was surprised as well. As I look back on the article and re-read what I published, it sounds a little rude and sarcastic…but I truly didn’t mean it that way. I was genuinely just surprised about people’s lack of knowledge on (what I thought) are basic financial terms.

    I never even thought about trying to define a dividend as an article, but that conversation provoked me to. I probably should have done like you and set out right away to put my own definition on it.

    Thanks for stopping by. Hope you’re having a great weekend.

  4. Mia says

    Hello Jason!

    This is Mia, i asked you the question about Vanguards Admiral Shares previously. Thank you for your response. I feel like a sponge reading and reading your blog posts, trying to educate myself.

    As I’ve said previously, I am 25 years old, and would like to adopt your strategy in dividend investing. Could you kindly give me a “dividend investment for dummies” which is literally a step by step process of how to purchase shares? For someone who is new to investment, I don’t even know how to start!

    I assume that step1 is to open a brokerage account, what is the step 2?

    Also, should I be purchasing these shares in the IRA account or in the simple brokerage account? My strategy is to buy and hold these until my retirement.

    Thank you!

    • says

      Mia,

      You may benefit from reading some of the books I’ve recommended in the past. They do a great job of explaining the basics:

      http://www.dividendmantra.com/getting-started/

      I also wrote an article last May that discusses what I’d do if I were starting all over again (ignore the ARCP recommendation, however):

      http://www.dividendmantra.com/2014/05/if-i-were-starting-all-over-again/

      You’re right in that the first step is to open a brokerage account (this is true no matter how you decide to invest). So you can pick your favorite discount brokerage firm and it’s very easy to open an account – I use Scottrade and have a few affiliate ads here on the site. When opening your account, you’ll have to figure out whether it’s going to be a taxable account or an IRA. Depending on how much you can save and invest, you may want to open both. I use a taxable account only, but that’s only because my timeline is so aggressive. I recommend maxing out tax-advantaged accounts for most everyone else.

      From there, it’s analyzing and purchasing individual stocks. For help on that, you may want to read this article:

      http://www.dividendmantra.com/2014/01/how-i-analyze-and-value-stocks/

      I hope this gets you started down the right path. Start slow and read a lot. I wouldn’t act until you feel 100% comfortable. At 25, you still have plenty of time on your side.

      Best regards!

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