It is common for an individual to receive questions from novice investors like “what are dividend stocks?“
There exists a very vague explanation of dividend stocks because the fundamentals behind dividend stocks rely heavily on the basics of dividends and how they work. So, to understand dividend stocks, one must understand what dividends are and how they function.
But, before getting into the heart of the matter, let us provide you with a gist about dividend stock definition.
Dividend stocks are the stocks of companies listed on the stock exchange. These companies provide regular dividends to their shareholders. Established companies tend to allocate regular earnings to their shareholders in the form of a dividend.
But, “what does dividend stock mean?” is a question that one can understand only after understanding the dividends and their basics.
Dividends are the benefits that a company extends to its shareholders. Public-listed companies can only develop these benefits, which are done through the company’s retained earnings.
These benefits can be provided in various kinds like cash and cash equivalents, shares, assets, etc. The dividends are paid from retained earnings only after other essential expenses of the organisation have been cleared.
The company’s board of directors has the right to decide the dividend rate along with the approval of the majority of shareholders.
However, it is not always necessary for a company to pay dividends to the shareholders. It might prioritise reinvesting those profits for growth and expansion of the business rather than distributing them to the shareholders.
The announcement of a dividend income declaration can substantially increase or decrease the company’s stock’s value.
There are several steps when it comes to dividends. The process of how dividends work is stated below. The steps are as follows:
Step 1
The publicly listed organisations have generated a substantial income, thereby accumulating a significant amount of retained earnings or profit.
Step 2
An organisational meeting is held in the organisation to decide if they should use these earnings for the growth and expansion of the business or if they should distribute them to the shareholders.
The management might also conclude by reinvesting a portion of the earnings in the business and distributing the rest to the company’s shareholders.
Step 3
If the majority of shareholders approve the declaration of dividend income, then the company proceeds to declare the dividend to the shareholders.
Step 4
The organisation decides to announce the important dates for the declaration of dividend income.
Step 5
It is scrutinised to learn if a particular shareholder is eligible to receive a dividend.
Step 6
If the shareholders are eligible to receive a dividend, then the dividend is paid to the shareholders.
On the contrary, if, after Step 2, the organisation votes in favour of reinvesting all the retained earnings into the business for its growth, expansion, productivity, and efficiency, then there will be no declaration of dividend.
However, it must be considered that if the earnings are reinvested or distributed as dividends, both of these financial activities tend to influence the organisation’s financial strategy.
There are several forms in which an organisation can pay dividends to its shareholders. But, the nature of the payouts depends on the type of shares, and there are different dividends for different shares.
However, there are two significant types of dividends provided by a company to its shareholders, and they are as follows:
Special dividends are the benefits paid to the ordinary shareholders of the company. When a company has accumulated a significant amount of retained earnings over the years of its business, it decides to issue a special dividend to its equity shareholders.
These dividends are distributed from earnings that do not have any immediate use in the coming future. Hence, instead of leaving the gains idle, distributing dividends is a better strategy to enhance the company’s market value.
Preferred dividends are the benefits distributed to the preferred shareholders of the company. These shareholders receive a fixed amount of dividend at fixed periods from the organisation. But, this dividend is earned only on preference shares.
Preference shares function less like shares and more like bonds. Preference shareholders do not receive voting rights, but the company is obligated to pay dividends to them.
There are many types of dividends. However, some of the most common types of dividends are listed below.
The list of the most common types of dividends are as follows:
Many companies pay cash dividends to their shareholders. Whenever dividends are delivered in the form of cash, they are wired electronically, or a cheque is provided to the shareholders instead of the dividend.
A few companies agree on distributing benefits to their shareholders in the form of tangible assets, real estate, or investment instruments. But, as exciting as it may sound, the idea of issuing assets is still rare among the companies in India.
Many companies distribute benefits to their shareholders in the form of stocks, and new shares are issued to existing shareholders in the name of dividends.
The companies usually distribute stocks on a pro-rata basis. The number of stocks allotted to a shareholder is decided based on the number of outstanding shares that the particular shareholder is currently holding.
The common notion is that dividends are the excess retained earnings distributed to shareholders as benefits. Mostly, the rate of this dividend is often decided by law.
The exceptional cases in which the dividend rate is decided by law are when the dividend payment happens in cash or when the dividend payments are responsible for the winding-up of the company.
Apart from such payments, the company can also offer warrants, new shares, a new company’s share, or any other financial assets in dividends to its shareholders.
Whatever may be the case, it should be taken into consideration that dividend distribution and declaration significantly affect the company’s share price.
One must consider that paying dividends to the shareholder might not influence the holistic valuation of the organisation. However, this well-thought decision might play a vital role in decreasing the overall equity of the organisation by the amount paid as a dividend.
To explain, once profits are distributed, it is irrevocably deducted from the books of accounts and cannot be reversed.
Furthermore, when a corporation distributes a dividend, its stock price may rise in the market. Investors might be willing to pay a higher price to receive dividends. Once the period of dividend eligibility ends. However, the share values begin to fall by a corresponding percentage.
When new investors are not considered valid for dividends, they are hesitant to pay the related premium, resulting in a drop in value. Similarly, if we believe that the market will remain optimistic until an ex-dividend date, the progress in the stock value may be more substantial than the dividend offered.
Regardless of the cutbacks, such incidents frequently result in a rise in the total value of a company’s shares. Investors must become aware of the crucial days concerning dividends to fully understand the dividend declaration’s influence on stock prices.
The stocks that yield higher dividends than marked standards are termed high-dividend yielding stocks. Dividend investing is a reliable method of accumulating wealth and helps provide and shield against inflation that bonds do not.
So, here are some factors one can look at before making their choice. Ways to pick the best dividend are as follows:
Strong cash position
Cash position is essential to consider when evaluating dividend-paying companies’ long-term profitability. Although any company can have a profitable quarter occasionally or once in a blue moon, only those with consistent annual growth should be considered while evaluating your investment choices.
The company must have a track record of consistently paying dividends in its last five years. Also, the stock’s dividend yield should always increase each year, and companies should have excellent cash flow to fund dividend programs for investors.
Investors should avoid dividend-paying companies with excessive debt. Companies with debt tend to naturally direct their resources toward debt repayment rather than dividend payment programs.
As a result, investors must scrutinise a company’s debt-to-equity ratio, and if it is more significant than 2.00, then investors should proceed.
While scrutinising a company’s numbers is essential, it is also crucial to look at the broader sector in order to develop a more comprehensive projection of future performance.
For example, an oil company may be doing well, but a drop in oil prices due to a specific economic situation will likely increase demand while decreasing supply. This could lead to a decline in stock prices and a reduction in dividend payments as the company cannot make enough profits.
Keep in mind that the behaviour of a sector can change over time. One should conduct an in-depth analysis to understand and review the current and future performance and how much that sector is prone to be affected in the future.
Let us see one more example of investing in the soft drink industry, listed companies like Varun Beverages and Orient Beverages. It has historically been a safe bet. Still, consumers are becoming more health-conscious as awareness can be seen. As a result, most beverage companies are shifting their focus to healthier/alternative drink options.
Similarly, many beverage companies are now shifting their product focus to diet and sugar-free alternatives as this new healthy era is boosting. However, this transition will take time, and investors should know this before putting their money into beverage companies. Hence, before investing in any industry, a thorough knowledge of its future prospectus is necessary.
To identify high-paying stocks, one needs to be observant as there is no particular set of dividend stocks that pay high dividends. The dividend stock that will give you a good dividend depends on your risk appetite and criteria of investing. If a company has N/A, which means not applicable, in the dividend yield section of its financial report, it means that the company does not pay any dividend.
Investors who want to buy stocks that pay a cash dividend can choose between equity shares and preference shares. When investors hear the term preference shares and how it facilitates regular and steady dividend payout delivery, they think it is the better deal.
But that is just one part of the story. Preference shares might offer higher dividends than equity shares as they have a fixed redemption prize. The preference shares come with a call option where the company asks the investors to sell back the shares after a specific period.
This call option is usually initiated five years after the issue of preference shares. If a preference share promises a substantial dividend rate, then there are significant chances that this company might exercise its call option soon. After the call option, the stock might be subjected to redemption, and you will not own it anymore.
Equity shares tend to have lower dividend yield. The equity shareholders are the last ones to receive dividends; hence they may not receive dividends when the company experiences a decrease in its profits. The prices of equity shares fluctuate more than preference shares, but in equity shares, there is no predetermined limit for the redemption prize, and you also do not receive a call for buyback of shares.
An investor should understand that in investing and dividend stocks be it equity shares or preference shares, there is a certain amount of risk involved. If you are investing for a short period, then you might gain quick returns. But, if you have decided to invest for the long term, then investing in individual stocks can increase your risk because the value of stocks can go down with time.
Hence, it is crucial to form a diversified portfolio to minimise risk. Many financial experts recommend index funds, a type of mutual fund because diversification gives you a low-risk investment option. The cost of index funds is also comparatively lower, and they provide dividends.
Here are a few things that an investor should consider before buying stocks:
A significantly high payout or yield ratio clearly shows that very little profit is being reinvested, and this can be easily derived from the formula. If the dividend is very high, the company is diverting less profit for reinvestment and more for dividend payouts.
The formula for calculating one of such ratios is as follows:
Dividend Payout Ratio = Annual dividend per share / Earnings per share.
Investors must stay aware of this before buying dividend stocks.
These ratios, as mentioned above, should only be used to analyse the company’s dividend payout situation and should not be the sole reason for investing or not investing in a company’s stock. Therefore, clarity of thought regarding the same is required.
Otherwise, even the highest dividend-paying stocks can turn out to be poor long-term investments because of a lack of examination of the past performance of the dividend. Hence, investors must consider these before selecting dividend stocks.
The price of a stock on the market is a moving figure, and during a trading session, it might alter every second, which, in turn, results in varied dividend yields. Hence, an investor must be careful when they select dividend stocks with the help of dividend yields.
Judging a company’s payout by looking at the absolute number available will never fetch precise results, and make no decisions based on these figures.
If company A pays out a dividend of Rs 100 per share, that does not speak highly of the company. And contrarily, the dividend of Rs 10 per does not reflect poorly on a company. The highest dividend-paying stocks are not always the best investments.
Investors should consider other metrics such as the company’s earnings, the number of outstanding shares, and various other metrics. Here’s where the ratios come into play. So, analyse these factors well before you invest in dividend-paying stocks.
The appealing part about dividend stocks is that investors can expect quarterly cash payments until they sell their shares. One should take all the above advice with a pinch of salt because it is already known that dividend stocks do not come without their share of risk.
Note that a company experiencing loss in its business operation might not pay dividends to its common shareholders.
The dividend payout ratio represents the percentage of the company's retained earnings that will be distributed as dividend income. But, a dividend yield represents the rate of return already distributed to the shareholders in the form of dividends.
The dividend payout is considered a valuable metric because it aids a company in efficiently allocating dividends among its shareholders. This ratio is mainly related to an organisation's cash flow, and it also reflects the amount paid by the organisation as dividends in a particular year.
An increase in a company's share price can cause a substantial decrease in the dividend yield rate.
The formula for calculating dividend yield is as follows:
Dividend Payout Ratio = Annual dividend per share / Earnings per share.
Dividend investors should be careful about four important dates when investing in dividend stocks. Keeping track of these critical dates is necessary for the investor if they want to receive timely dividend payout benefits. The four dates are as follows:
There are four critical dates for dividend investors, and the ex-dividend date is one of those four important dates for investors. The ex-dividend date is usually set one business day before the record date. The investor needs to own the dividend-paying stock before this date to receive the future dividend payment.
If an investor does not purchase shares before this date, then purchasing the shares on or after this date is of no use because they will not be eligible for receiving the dividend payment. Hence, the seller will receive the dividend payment in this situation instead of the current buyer.
You will not receive the dividend unless you purchase the security before its ex-dividend date. The purchase and sale of stock follow T + 2 settlement which means it takes two business days for the transaction to settle. Hence, one should keep this in mind before buying the stock.
The payment of regular dividends happens quarterly in synchronisation with the cash earning cycle of the company. But the payment of the special dividend is a one-time thing, and the company can decide to pay it at any particular time.
Please note that by submitting the above mentioned details, you are authorizing TradeSmart to call and email you and also to send promotional communication even though the contact number may be registered under DND.
Please note that by submitting the above mentioned details, you are authorizing TradeSmart to call and email you and also to send promotional communication even though the contact number may be registered under DND.
Open Demat Account &
Trade @ Rs15 per order.
“Filing of complaints on SCORES – Easy & quick”
Please note that by submitting the above mentioned details, you are authorizing TradeSmart to call and email you and also to send promotional communication even though the contact number may be registered under DND.