How do Stock Dividends Work?

One of the added benefits of owning stocks is the potential to receive dividends as a reward for ownership. In a company’s early years, growth can happen quickly. The majority of cash flow is reinvested to fuel further expansion and growth. After a certain point, however, a company’s growth will slow. Management may decide that, in order to maximize shareholder value, profits are better off being distributed instead of reinvested back into the company. In this article, we’ll uncover how stock dividends work, how dividends can impact the stock price, and how to harness a dividend’s power to compound over time to help you achieve your financial goals.

Cash Dividend Example

Microsoft was founded in April of 1975 and went public almost 11 years later in 1986, but didn’t announce its first dividend until nearly 16 years later in January 2003. At this point, Microsoft had been wildly successful, but growth had started to level out. They also had a stockpile of cash in the bank, and couldn’t find enough worthwhile projects to spend it on. As a result, a dividend was announced. Microsoft has paid a quarterly dividend ever since.

For long-term investors, dividends can play an important role in building wealth. Many companies pay dividends on a quarterly basis. For investors who reinvest dividends year after year, they’re able to take advantage of the power of compounding, boosting their investment returns.

What Comprises a Dividend?

Dividends are an investor’s share of company profits. As an owner of a public company, you’re compensated for allowing the company to use your capital. If a company continues to raise dividend payouts, it’s typically a strong indication that profitability is continuing to improve. Companies can issue a dividend in 3 main ways: cash, stock, or extraordinary.

A cash dividend is the most common and simply a cash payment of your share of a company’s profits.A stock dividend, on the other hand, awards additional whole or partial shares of stock instead of cash. Lastly, extraordinary dividends are one-time dividends issued outside the norm when a company pays cash that was previously held back from shareholders.

There isn’t a specific rule as to when a company can pay a dividend. The board of directors retains full discretion in the matter and can issue a dividend at any time. Conversely, they can also stop paying a dividend at any time. However, this can cause an adverse market reaction (more on that in next section below). Therefore most companies are consistent in the frequency in which they pay dividends, as often as quarterly.

Impact on Stock Price

Dividends can have a direct impact on the movement of a stock price. If a company reduces the dividend it pays to shareholders, the stock becomes less attractive, fewer investors buy it, and the share price goes down. The opposite is true if a company raises its dividend – the stock becomes more attractive, more investors buy it, and the share price goes up. In general, though, stocks that pay regular dividends see less price volatility than those that don’t (see related: Diversification: The Key to Maximizing your Investments). This is due to the quasi-bond nature of dividend-paying stocks. Meaning, due to the adverse market reactions of discontinuing or reducing dividend payments, most companies avoid doing so. As a result, investors can have a high degree of confidence they’ll receive dividend income as long as they hold their shares. This is very similar to a bond, but with the added bonus of being able to participate in share price appreciation as well.

How to Harness the Power of Compounding

In order to harness the power of compounding with dividend-paying stocks, simply reinvest the dividends you’re paid. Rather than taking the cash, buy more shares of the same company.

Many dividend-paying companies make this an easy task by offering what’s known as a Dividend Reinvestment Plan (DRIP). DRIPs offer a number of advantages to investors. First, they automate reinvesting your dividends back into your stock holding. Saving and investing works best when you can automate the process to the point where you don’t really have to think about it (see related: Best Way to Budget: Automation) Second, most company-operated DRIPs are commission-free since they bypass the use of a broker. This is particularly beneficial for smaller investors since commission fees for smaller purchases are proportionately much larger.

Lastly, some companies will offer investors using their DRIP the ability to purchase additional shares at a discount. If you’re able to buy in at, say a 5% discount, and not pay any commission-fees for doing so, you’re effectively purchasing additional shares at a more advantageous price than going through a broker. If you stretch this out over a 30-year period by using a diversified dividend-paying stock portfolio, remaining patient through market volatility, staying invested, and continually reinvesting dividends, you start to see how powerful this strategy can become for building wealth.

How Can I Apply this to my Strategy?

Since many companies pay dividends, most investors are likely to be receiving dividends in some form or another from their investment portfolio. For long-term investors, dividend-paying stocks are a practical addition to almost any portfolio. Retirees, for example, can use dividends as income, while young professionals can use dividends for growth through reinvestment and compounding. Both also have the added benefit of being able to experience growth from share price appreciation.

Even if you don’t quite have the assets necessary to purchase individual dividend paying stocks, ETF’s or index funds that hold stocks will distribute their dividends. The same exact strategy can be applied to ETF’s and index funds and reinvesting their dividends. Take note, however, that over time, particular holdings will become more heavily weighted than when you originally built the portfolio. Either due to the price increase and/or dividend reinvestment. This oftentimes leads to a riskier portfolio than you had originally intended, since positions that grew, now hold a larger allocation in your portfolio. Be sure to rebalance back to your original allocation annually.

If you’re wondering how dividends might function in your investment portfolio or need help aligning it with your financial goals, schedule a free consultation with us today.

Chad Rixse grew up in Anchorage, Alaska, but has lived in the Seattle area since 2007. He majored in Spanish at the University of Washington where he honed his fluency in the language and discovered his passion for travel and connecting with other cultures. He’s a self-professed golf addict who can never seem to get his fill despite still struggling to break 100.