Dividends are payments made to owners of shares of stock, as compensation for owning the stock. Payments can be made by several methods, but most dividends are paid in cash.
Dividends are a distinct concept from interest. Interest is the payment on a debt, paid to a holder of bond, or other debt instrument. Non-payment of interest results in default. Dividends are paid to owners, at the discretion of management of the company.
An investor needs to understand the distinction between cash dividends and stock splits and stock dividends. Splits and stock dividends are only adjustments in the price of the stock, and do not result in payments to the shareholder.
Not all companies pay dividends. Companies that do not pay dividends are making a decision to invest those funds back into the company.
There is not necessarily a correlation because stock price and the size of the dividend. A growing company may choose not to issue a dividend in order to fuel the growth of the company. On the other hand, a company in distress may need to keep the cash to fund current operations.
The yield of a company’s dividend is found by comparing the amount of the dividend divided by the stock price. A company with a share price of $10 and an annual dividend of $1 will show a yield of 10%. ($1 divided by $10)
Dividends on stocks are often paid quarterly, but can be paid on any schedule. Sometimes companies will pay special one-time dividends, which can distort the annual yield calculations.
Yields on dividends can be overstated when compared to other investments. An investor buying a stock on the day before the ex-dividend date and holding overnight will earn the dividend. The stock price will immediately revalue (drop) by the amount of the dividend.
Unlike a bond or money market account, no interest will accrue in the period between the ex-dividend date and the payment date. For example, a one month delay in paying the dividend will reduce the effective interest rate by 1/12.
Choosing a stock based on the dividend that it pays can be an important part of an overall investment strategy. A mixture of stocks with a history of paying dividends can be part of a balanced portfolio.