EVERYBODY loves dividends…right?
But do you know why? Dividends have always been very popular, however, when interest rates go down, dividends become more and more familiar.
There are certain types of investors who seek yield. They could be pension funds, endowments, or individual investors who are retired who live off the yield of their investments. When interest rates go down, it becomes a more profitable investment (something) to invest in dividend stocks as the higher yields coming from dividends returned more than fixed income instruments like bonds.
A dividend is pretty straight forward, however, many people get confused with the different types of dividends available. Let’s go through them and see which one of the following correctly describes the dividend yield?
What is a Dividend?
While some may consider talking about what a dividend is trivial, it is important to be on the same on the same page before we can move forward.
A dividend, in most cases, is a payment made by a publically traded company to its shareholders. When publically traded companies make money and make profits, they are free to do whatever they like with those profits. They can reinvest in new facilities or products, or they can pay shareholders in the form of a dividend.
This payment, which usually it distributed four times a year, comes in the shape of a cash payment into the shareholder’s brokerage account. On rare occasions, dividends can be part of reinvestment plans where the dividends are used to instantly buy more shares of stock. These types of dividends are known as share repurchases and are usually done by managed investment funds.
A dividend is paid out as a fixed dividend per share, rather than a predetermined dividend yield. Let’s look at the example with Apple to show how dividends are a payment per share and not on a percentage basis.
Apple Inc. Dividend
Right now, Apple has a dividend of $2.28 per share which is spread out over four cash payments over the course of the year on predetermined dates.
With the stock price at $140.64 (wow, Apple has gotten up there!), that makes the dividend per share a 1.62% dividend yield.
If Apple were to spend the next few months in freefall and the dividend rate remained intact, and the stock price went down to $110, the dividend payout would still be $2.28 per share. However, the dividend yield would be higher as the rate stayed the same but the price of the stock went down.
Again, the dividend payout remains the same, and the dividend yield changes pretty much all day every day.
Not All Dividend Were Created Equally
Most people look at the dividend yield of stock or ETF and jump right in assuming they like the yield they see. However, not all dividends were created equal.
For a majority of stocks and ETF’s, their dividends are known as qualified dividends or those which are taxed at the capital gains rate of roughly 18%. The example we used earlier for Apple would be a qualified dividend if we were a shareholder of Apple for more than 60 days. That $2.28 you collect over the year would be taxed at roughly 18% rather than taxed as ordinary income.
On the other hand, there are some instances where dividends are non-qualified dividends and are taxed as ordinary income. REIT’s are an example of companies who pay out large dividends and the dividend received is not able to be taxed as capital gains. Rather that being able to pay eighteen or so percent, recipients of dividends which are non-qualified must pay full income tax on them, which is typically at least double the capital gains tax.
Why Would a Company Pay a Dividend?
While the majority of companies do pay a dividend to shareholders, there are some companies who do no. For example, Google does not currently pay a dividend (it does not mean that they never will).
These companies typically have a reason for not paying a dividend. Remember, a dividend is a share of profits from the company. Some companies, like Google, prefer to take their profits and reinvest all of those profits back into their business rather than pay out shareholders with the excess cash.
This is not a knock on dividend stocks, however, it is very rare to see companies that are focusing on growth pay a dividend as these companies are putting all of their resources behind growing the company. This is why many see a dividend as a form of financial engineering in order to attract many types of shareholders rather than a tool to improve the company.
Which One of the Following Correctly Describes the Dividend Yield?
The dividend yield is the percent of cash taken out of the stock in order to pay the dividend to shareholders. The dividend amount is typically fixed, while the dividend yield is the one that fluctuates all day.
While we at Stony Book Securities rarely care about dividends, there are a few opportunities where a stock is beaten down, which raises the dividend tremendously, and provides excellent opportunities to us.