An understanding of dividends is essential for any investor. Many new traders are confused about them, but they are not overly complicated. The following information gives a basic overview of what dividends are, how they work, and how they are collected. There are many additional terms and concepts out there in the world of dividends. However, the following information is intended to include only the most essential information. So, what is a dividend, exactly?
The Concept of a Dividend
When a corporation decides to pay its shareholders, the payment is called a dividend. A corporation is under no obligation to pay dividends. Therefore, some successful companies do not pay them. Cash is the most common payment method.
When a shareholder retains ownership of a given stock at the end of a specified trading day, that shareholder is guaranteed a dividend payment. There are two common forms of payment: cash and stock. Dividends date many hundreds of years back into the English stock system.
Corporations choose to pay dividends when they have earned notable profits. Any profits that are reinvested back into the business are called retained earnings. A corporation is free to split profits between retained earnings and dividend payments however it chooses.
What is a dividend cash payment, then? The cash payment happens when a company decides to pay shareholders a portion of its profits. In this case, the company issues checks or direct deposits. Afterward, the payment funds are subtracted from each share of the stock’s market value. If the company pays out $0.39 per share, for example, each share of stock is reduced by $0.39.
If they are not paying a dividend in cash, then what is a dividend stock payment? Instead of paying shareholders in cash, the company may pay with additional shares of stock for each share a person owns. The company then readjusts the price of each share to balance the stock’s market value.
Here’s how stock payment works. However, keep in mind that companies actually pay fractions of a share for each share you own:
- You own one share of XYZ.
- The stock is worth $2 per share.
- XYZ pays you a dividend of one share for each share you own.
- You own two shares of XYZ after payment.
- Both of your shares of XYZ are readjusted to be worth $1 per share.
The Advantages and Disadvantages of Dividends
Many traders agree that dividends exist to send market signals. This is the single greatest advantage that they have. A dividend payment demonstrates that a company is healthy and worth investing in. Cash payments also help to keep a stock’s value under control.
On the other hand, many investors believe that dividends are meaningless. Dividends reduce the value of each share. Subsequently, that means that the shares must rise to regain their previous worth. Cash payments can lead to heavy taxation. Moreover, payments in shares of stock can potentially dilute a stock’s value when investors sell them off.
Advantages of Dividends
When a company issues a large enough dividend payment per share, this sends positive signals about a company to the marketplace. Many people do not want to invest in a company with weak profits. Dividends represent profit. This means that large dividend payments often come with increased buying activity. This drives a stock’s price upward.
What is a dividend good for when a company is weak, though? A company with weak profits may still attempt to pay dividends. To not do so would create investor panic. In this way, a dividend can help save a company’s image for the short term. However, this only works if the company’s payment is large enough.
Cash payments allow for an investor to acquire profits from a successful company without selling off shares. This keeps many investors from selling off positions to guarantee profits from upward trends in a stock’s value. Historically speaking, investors are usually so happy with their dividend payments that they bid a stock’s price higher in return.
Stock dividend payments are exempt from many different forms of taxation. The company is giving its shareholders an asset, not money. The investors may choose to sell those assets and convert them into cash. However, they are only taxed on financial gains or losses in this way. They are not taxed for the full value of the shares sold.
Stock payments give investors more upward leverage during bullish times. If a person owns one share of a stock, they will gain $1 for each $1 that the stock rises in value. If a person owns two shares of that same stock, an increase of $1 in the stock’s market price will cause the investor to gain $2 in equity.
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The Disadvantages of Dividends
Large cash payments per share alert investors to a stock’s inherent value. However, what is a dividend payment good for when it’s small? The answer is not much. Smaller dividend payments can send negative signals to the market, and this can drive a stock’s price down in the long run.
What is a dividend worth to the government? During tax season, many investors realize the inherent problem with a cash dividend. Most governments see cash dividends as a form of income, not a capital gain. This means that the payment is taxed for the full amount received. If a person sells stock, they are taxed only on the amount of money gained or lost during the buying and selling process.
Another disadvantage to the dividend is the lack of gain in equity. When a person receives a cash or stock payment, their shares of stock in the company are adjusted for the payment received. There is zero net gain or loss in equity. This is exactly why some people abhor dividends.
Stock dividends increase a person’s overall market exposure. Rises and falls in a stock’s price cause a person’s equity to increase or decrease according to the number of shares owned. What is a dividend worth if the stock price goes down after payment, then? If the stock price goes down after a stock dividend payment, the investors will lose more money than they otherwise would have.
Dividends also affect the value of options contracts. When they readjust the price of a stock due to a dividend payment, the value of put contracts increases. The value of call contracts decreases. Many options investors have lost significant money due to a dividend payment that they were unaware of.
If the investor sees no actual gains or losses in equity, what is a dividend good for? The truth is that dividends are mostly for the company, not the investor. A corporation issues dividends to show its relative strength. Many investors appreciate the periodic payments that dividends provide. However, they aren’t vital to a successful portfolio.
Some theorists continue to see dividends as meaningless, despite the praise they receive in some circles. Any investor can sell off a small portion of their stock to create a cash-style dividend payment. This can be done at any time, with less taxation than an official dividend. How do you feel about dividends? Feel free to share your thoughts, questions, and experiences concerning this important trading topic.
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