How Dividends Work? An Ultimate Guide

Understanding the concepts of dividends and how dividends stocks work can be confusing for any new investor. 

That is why at What Stocks To Buy we have written this dividend how-to guide which breaks down everything you need to know. In this post you will learn:

 

Table of Contents

What Is A Dividend And How Does A Dividend Work?

A dividend is a distribution of profits by an organisation to its shareholders.

When an organisation earns a profit or surplus capital, it can pay a proportion of the profit as a dividend to shareholders. The remaining profits will usually be re-invested into the business for growth, leading to increased profits and in-turn dividend returns the following year or dividend pay-out window.

Why Do Companies Pay Dividends?

You may be wondering how a dividend works ? A company will pay a dividend for many reasons. The most significant reason is that paying dividends to shareholders is a reward scheme. It creates a sense of trust which makes that company more investable, financially stable and ‘safe’ investments for buy and hold investors.  

As more shareholders are rewarded with dividends the company would hope that the dividends paid out would then be reinvested back through the purchasing of more shares by the same shareholders. This creates a healthy growth cycle and improves future business prospects. Shareholders are rewarded with profits in the process.

When Are Dividends Paid?

Stocks that offer dividends otherwise known as dividend stocks are paid out an average of four times a year on a quarterly basis. Some companies may choose to pay their dividends monthly, annually (once a year), semi-annually (twice a year), or may opt to have no set schedule otherwise known as “irregular” dividends. 

To receive dividends, you must have a purchased share in the company before the ex-dividend pay-out date. This date is normally one business day before the date of record. 

The date of record is the date when the company reviews its list of shareholders. The dividend profits you receive will be based on the volume of shares you own in that particular company otherwise known as DPS (dividends per share).

Dividend Example:

McDonald’s has four dividend payouts per year (Quarterly) of $1.25 per quarter which will total $5.00 for 2020. Therefore, if you own 100 McDonalds shares you will receive $125 each quarterly payout making a total of $500 in dividend profits for 2020.

How Are Dividends Paid

Dividends can be paid in cash but can also be distributed in the form of additional stocks and shares. In both cases, it is dependent on their current ownership stakes.

If you invested through a trading platform, dividends will be paid back directly into the investment platform you used to invest with. An example of some UK and USA investment platforms are:

UK Trading Platforms

  1. eToro – Social and copy trading stockbroker with 0% commission
  2. Capital.com – CFD broker with AI trading and over 2,000 shares
  3. FXCM – Long-standing stockbroker with MetaTrader 4
  4. Plus500 – Low-cost CFD trading platform known for its low spreads
  5. IG – Share dealing broker with over 10,000 shares
  6. DEGIRO – Popular stockbroker with a variety of international shares
  7. Fidelity – Best research experience

Source (https://buyshares.co.uk)

 

USA Trading Platforms

  1. TD Ameritrade – Best for overall and beginners
  2. Charles Schwab – Best for IRA accounts
  3. E*TRADE – The best web platform
  4. Interactive Brokers – Best for professionals
  5. Merrill Edge – Best rewards program
  6. TradeStation – Best platform technology

How Can Dividends Affect Stock Prices?

Dividends can be an impactful and successful investment opportunity for your stock portfolio. Dividends can work as ‘cash cows’ offering you quality returns for minimal effort. 

Dividends can affect a stock price when for example a financially stable company such as McDonald’s continues to pay out dividends to their shareholders. McDonald’s will be seen in the investing` community as a “Safe Stock” or “Financially Stable Stock” leading to continual, steady growth of investment year on year. With the increase in investors, the stock price will increase as like many assets supply and demand plays its role in controlling the market price. 

The share price will increase if more investors want to buy a share than sell it (Demand). If more investors want to sell stock rather than buy, the price will reduce (Supply). This leads to a price increase/decrease cycle when particular dividend stocks are more sought-after or undesired during different times of the year (the ‘demand’ or ‘supply’ cycle).

What Stocks To Buy Statistics Chart

What is Dividend Reinvestment?

Our team at What Stocks To Buy agree with you. Cashing in on your first dividend profits can be extremely satisfying. However, we believe you will gain even greater satisfaction through a reinvest strategy. When you reinvest dividend profits, you generate a profit cycle that far exceeds your original dividend profit margin without using your own money. Using McDonald’s as a case study let us take a look at how a reinvestment strategy would impact on your final profit margin.

Case Study

  • McDonald’s has four dividend payouts per year (Quarterly) of $1.25 per quarter which will total $5.00 for 2020.
  • McDonald’s stock price before the first ex-dividend date in March was $147.80. If you own 100 shares that is $14,780.
  • Let’s say you wait for the first quarterly dividend pay-out window (March 16th). You would make $1.25 on each share you own which is a dividend profit of $125.
  • Now if you chose to reinvest those profits by purchasing more McDonalds shares you would add 0.85 ($125 ÷ $147.80 = 0.85) to the already owned 100 shares for no extra cost, totalling 100.85 shares.
  • This inflates your total McDonalds investment portfolio from $14,780 to $14,906.
  • The next payout window is June 15th. If you held your current investment until the next dividend payout window (June 15th) you would receive a further dividend pay-out of $126.06.
  • This would be a total dividend payout of $251.06 for the two windows. Your McDonalds stock portfolio would now be $15,031.06.
  • The McDonalds stock price also increased to $190.48 by June 15th from the original share price $147.80.
  • Your total McDonalds investment portfolio would now be $19,299.06.
  • As McDonald’s have two more payout windows, you can see how a simple dividend reinvest strategy can quickly multiply into much larger profits over time.
  • The key to a good dividend reinvestment strategy is long term gains of short-term profits so be patient, stick to your strategy and enjoy the long – term growth.

How Stock Dividend Yield Works

The dividend yield is a price ratio that fluctuates up and down depending on the share price. This is where the term undervalued or overvalued comes from. A dividend yield follows the formula of:-

Formula:

Dividend Per Share ÷ Share Price = Dividend Yield

This can also be known as a company’s total annual dividend payments divided by its market capitalisation. The dividend yield is often expressed as a percentage.

Formula: 

Dividend Per Share ÷ Share Price = Dividend Yield

             $1

_________________   

            $30

Dividend Yield (3%)


  • If you own $10,000 shares of a company and that stock has a 3% dividend yield margin you will make $300 profit each dividend payout window.
  • You can also look at it from a reinvestment point of view. As each share is worth $1 you can purchase 300 new shares for free by incorporating the dividend reinvestment strategy we spoke about previously.

How The Stock Share Price Affects The Dividend Yield

 

Law Of Dividends

  • If the share price goes down the dividend yield goes up. Therefore, if you invest when the share price is low you will make more profit once the share price increases.

Example:

             $1

_________________                      

           $30

Dividend Yield (3%).

           

3% of $10,000 = $300 (Profit)


            $1

_________________   

           $25

Dividend Yield (4%)


4% of $10,000 = $400 (Profit)

 

             $1

_________________                

            $20


Dividend Yield (5%).


5% of $10,000 = $500 (Profit)

 

  • If the share price goes up the dividend yield goes down. Therefore, if you invest when the share price is high you will make less on dividends as the stock price decreases.

Example:

           $1

_________________  

          $30

Dividend Yield (3%)


3% of $10,000 = $300 (Profit)

 

            $1

_________________   

           $35

Dividend Yield (2.8%).


2.8% of $10,000 = $280 (Profit)

 

             $1

_________________   

            $40

Dividend Yield (2.5%).


 2.5% of $10,000 = $250 (Profit)

How To Know If A Stock Is Worth Buying

We spoke about an overvalued or undervalued stock above. Knowing if a stock is overvalued or undervalued will be the primary indicator to buy or sell. 

Below I will outline what makes a stock undervalued or overvalued and how you can use these signals to buy at the right time. 

All dividend stocks will have an average dividend price per year. You can find this by following the below steps:

  • Use the search bar to find your stock

Yahoo Finance search bar

  • Go to “Statistics”

Yahoo Finance Statistics Section

  • Scroll down until you see “5 – Year average Dividend Yield”

All dividend stocks will have a live dividend price. You can find this by following the steps below:

 

  • Use the search bar to find your stockYahoo Finance search bar
  • Go to “Summary” and look for “Forward dividend & yield”. This percentage is your live dividend yieldYahoo Finance Dividends

A Stock is undervalued = The current dividend yield is greater than the average dividend yield  

A Stock is overvalued = The current dividend yield is lower than the average dividend yield

 

Example: 

What Stocks To Buy Dividend Graph

  • You always want to buy a stock when it is undervalued as you will get a higher dividend yield pay out each window. Focusing on undervalued stocks will highlight the best dividend stocks on the market and profitable high dividend stocks. 

How Much Tax Do I Pay On Dividends?

You can pay up to 7.5% rate on dividends for basic rate taxpayers (up to £37,500 on top of the personal allowance for the 2020/21 tax year). This could also be 32.5% on dividend income between the higher rate threshold (£37,501) and the additional rate threshold (£150,000). 

You could also have to pay 38.1% on dividend income above the additional rate threshold of £150,000.

Can You Live Off Dividends?

It is a common question that many of our members ask at What Stocks To Buy. Can you live off dividends? Well in the simplest of answers… yes you can. But you would have to have a large investment portfolio over a long period of time usually 10 – 20 years to generate enough dividend revenue to last your full retirement. 

A simple reinvesting plan like we discussed above combined with a health investing portfolio will pave the way to a successful and stress-free retirement. At What Stocks To Buy we help to build your investment portfolio by offering you weekly and monthly stock options.

All you have to do is invest in the stock options we give you saving you time and money on doing the research yourself.

Can You Get Rich Off Dividends?

Our members ask us are dividends stocks worth it, can you get rich off dividends? Well yes but as discussed above only if you have a long-term reinvestment plan with a healthy combination of dividend stocks and a sell/buy investment portfolio. 

At What Stocks To Buy we help our members become generate passive income with little to no hassle. We grow their investment portfolio by offering weekly and monthly stock options. All you have to do is invest in the stock options we give you, saving you time and money on doing the research yourself. 

This is not a get rich quick scheme but rather a simple and less time-consuming way to invest in stocks with little risk. Leave the research to the experts and sign up to our free trial today

How Can I Avoid Paying Tax On Dividends In The USA?

There are many ways in which investors can avoid paying tax on their dividends. They could use tax-shielded accounts. If you are saving money for retirement, you may not want to pay taxes on dividends so it could be worth opening a Roth IRA. Once the dividend profit is in there, you don’t have to pay taxes as long as you take it out in accordance with the rules. 

We at What Stocks To Buy would always recommend a reinvestment plan to avoid paying taxes and continually growing your profits for free each dividend payout window.

How Can I Avoid Paying Tax On Dividends In The UK?

A number of our UK members have also asked us what the ways are to avoid paying taxes on dividends. Below we have listed several ways such as opening up an ISA allowance. You can open up an ISA allowance on the first day of a new tax year and move your money into that account directly from your investment portfolio. You can also split the profits with your spouse and move profits into their accounts to either reduce their amount of tax paid or increase the allowance before paying taxes. 

If you are retired and trying to make money on the side from dividends you can move your dividend profit into a pension allowance scheme either through your bank or building society. You will avail of larger allowances by opening up a variety of different channels. Finally, you can follow the What stocks To Buy dividend reinvestment strategy above and use your growth investments as a way of retaining profits and not paying taxes. 

If you would like to grow your investment portfolio while taking advantage of dividends you can Sign up to our free trial today and get best buy stock suggestions directly to your email on a weekly and monthly basis. Let What Stocks To Buy help you make a side income.

List of 25 Dividend Companies

We have listed some of the best dividend stock companies who pay high dividends to their shareholders. Some of the highest dividend-paying stocks are listed below:

Stock Symbol 

  1. BNS
  2. TRP
  3. NHI
  4. CM
  5. MTB
  6. LYB
  7. BMO
  8. CHCO
  9. STX
  10. SWX
  11. SAFT
  12. BOH
  13. TD
  14. BXP
  15. EIX
  16. PFG
  17. RY
  18. CFR
  19. SLF
  20. PNW
  21. MMM
  22. ADC
  23. MO
  24. IBM
  25. DTE

What Are The Four Types Of Dividends?

  • Cash Dividend: A cash dividend is the most popular form of dividend pay-out. A cash dividend is a payment made by a company out of its profits and will be shared with investors in the form of cash, cheque or electronic transfer. The amount a shareholder receives is dependent on the number of shares they own in the company. It is also a way for organisations to transfer economic value to the shareholders.

 

  • Stock dividend or Scrip: A stock dividend also known as Scrip is when a company issues additional shares to common shareholders rather than in the form of cash, cheque or electronic transfer. A company may pay out stock dividends to ensure they get economic growth as investors will be more likely to continue investing rather than selling if their growth margins continue to improve each pay-out window. This is very much like stock splits, stock dividends dilute the share price, but like cash dividends, they do not affect the overall value of the company. SCRIP dividends are exempt from stamp duty and dealing charges. Companies can keep capital within the business.

 

  • Property dividend: A property dividend is an alternative to stock or cash dividends. A property dividend can either include shares of a subsidiary company or any physical assets owned by the company such as inventories, real estate or equipment. This is rare and is usually not the standard payment method for dividends. It is usually an agreement set-up upon investment between the company and its shareholders. This may be seen more in private investments rather than on the public stock exchange.

 

  • Liquidating dividend: A liquidating dividend is a form of payment that an organisation makes to its shareholders during a full or partial liquidation. This form of distribution is usually made from the company’s capital base. As it is a return of capital, this distribution is typically not taxable for shareholders. A liquidating dividend is different from regular dividends that are issued from the company’s retained earnings or operational profits.

Conclusion

  • In this blog post we at What Stocks To Buy tried to compile a how-to guide to dividend stock investing. Throughout this blog post, you will learn about what a dividend stock is, how companies pay dividends and when dividends are paid. 
  • We have included case study examples along with formula breakdowns for how dividends affect stock prices, a strategy for dividend reinvesting and how stock dividend yield works.
  • We have included how a stock share price is affected by dividend yield and when a stock is overvalued or undervalued making it worth buying. We have included and answered questions asked by our members which include how much tax you pay on dividends, can you live off dividends and can you get rich off dividends. 
  • Our members also asked us how they can avoid paying taxes on dividends in both the UK and USA. We thought it would be useful to give you an idea of dividend companies, so we have included a list of dividend companies to choose. These are high dividend yield stocks and offer qualified dividends to investors. Finally, we have explained the four types of dividends you would usually see through your investing career.
  • At What Stocks To Buy we have created a stress-free approach to investing. We do the research and we suggest the stocks that you should invest in. 
  • Let us help you grow your investment portfolio by using our stocks suggestions to make a profit. Sign up to our free trial today and start making passive income without the stress.

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