As a form of bonus, well-performing companies distribute dividends to stock or share investors. The bonus may come in various forms, but it is a reflection of a stockholder’s share in a company’s earnings. Thus, an investor who holds several shares gets a bigger bonus.
Rookie investors must understand how dividends work and why it’s a crucial pre-investment factor to keep in mind. If you consider yourself as an investor, read on to find out more.
How Do Dividends Work?
Dividends are drawn from a company’s net profits. It can be paid annually or on a quarterly basis, depending on what the board of directors agrees on. Some companies, however, payout cash or stock dividends quarterly.
A dividend is distributed to shareholders and paid, based on how many shares an investor owns. Thus, when a company decides to pay each USD$4 in dividend to each share, an investor will receive a dollar for each share per quarter. If a stockholder owns 200 shares, they’ll get USD$200 every three months.
However, most beginner investors who aim to earn short-term must be careful in buying shares from a newly-formed company, no matter how promising it may be. That’s because most start-ups reinvest their net profits to ensure company sustainability and growth.
Why Dividends Are Important To Investors
Businesses may pay a dividend in the form of cash or additional stocks. Regardless of the type of dividend paid out, these earnings are essential to investors for the following reasons:
- Dividends Guarantee Initial Investment Returns
While there are some levels of risk involved in all types of investments, dividends are always welcome to investors. No investor will buy stocks from a company where they’re not expecting to get any form of remuneration.
One of the primary considerations for an investor is the period in which they’ll get their initial investment back. This is true even when a person engages in high-risk investments. This payback serves as an investor’s guarantee that they’re getting their money in a specific period based on the company’s performance. A stock’s dividend yield can be calculated by taking the stock’s value and dividing the annual dividend. Otherwise, you can log on to most financial websites to help you.
- Dividends May Cushion Inflation
When paid regularly, dividends can help investors cushion the impact of inflation. Investment returns are primarily impacted by inflation. When inflation happens, an investor’s purchasing power reduces, depending on dividend yield. A dividend yield represents how much a company pays out in annual dividends in relation to its stock price and is expressed in percentage form.
For instance, if an investor has a share that increases 5% in a year, but the inflation rate during the same period stands at 6%, the investor loses one percent of its stock earnings. If the opposite happens, an investor’s purchasing power increases by one percent. In most cases, dividend yields often outperform inflation, especially when paid quarterly.
- Dividends Indicate A Company’s Value
Dividends are crucial for investors because it provides them with an idea of a company’s worth. While most people may only look at the company’s financial records to understand its performance, a financial statement may be manipulated to show positive performance. This practice is done on rare occasions to project a positive image, as the public company offers shares to more investors.
However, without actual cash flow, a company won’t be able to pay dividends. And as dividends represent cash earnings that the company has incurred, it’s a better indicator of its value.
- Dividend Payments Impact A Company’s Market Value
Picking up on the previous point, dividend payments impact a company’s market value. More often than not, a company’s stock price dips slightly each time they pay dividends to stockholders. When an entity pays cash dividends, it can no longer reinvest the cash to the company, restricting growth and reducing its assets.
This reduction in the company’s market value may not be as noticeable, especially considering factors like inflation. However, a minor decrease may become more evident when companies pay a one-time dividend. Also, a special dividend occurs when the company pays out all shares of its common stock, distributing accumulated profits.
- Dividends Provide Tax Advantages
Gaining cash dividends as extra income is one way to ensure more cash, being that dividends, unlike fixed-income investments, are tax-advantaged. That’s because taxes for qualified dividends are lower compared to most income and investments returns. For instance, the Internal Revenue Services (IRS) only takes anywhere from zero, 15%, or 20% from dividends depending on an investor’s taxable income and status.
The Bottom Line
Before investing in stocks, prospective investors need to check a business’s stock performance and dividend payments. This ensures they’re getting their investments paid back in the shortest possible time.
With the help of this article, a newbie investor can pick out a good investment from a bad one by understanding how dividends work and how they can provide a general view of a company’s value.