What Are Dividends? A Simple Explanation for New Investors

Ever wondered how investors make money beyond just buying and selling stocks? Most people think that you have to set aside massive amounts of money to buy real estate or take a leap into starting your own business.

That is simply not the case!

In fact a huge benefit is that you don't have to take out massive amounts of debt such as you would to acquire an investment property or fund a business.

Dividends are a powerful way to earn passive income from the stock market. The best thing is that you can make it your primary investment strategy or simply a supplement to building other streams of income.

Whether you're a beginner or just curious, understanding dividends can help you make smarter investment choices. In this guide, I'll break down what dividends are, how they work, and why they can be a game-changer for your portfolio.

What Are Dividends?

Dividends in simple terms are payouts from a company to its investors. Companies pay dividends to shareholders in order to reward them for investing in the first place.

You can earn a dividend if you own stock in a company that pays them. I stress, "if a company pays them", because not all companies do. This factor alone doesn't necessarily mean that companies that don't pay dividends are necessarily poor options to consider.

You see, when a company is profitable, it has a surplus of money from its operations called retained earnings. Depending on what stage of the business cycle a particular company is in will determine what they decide to do with those retained earnings.

For instance, companies that are in the earlier, more growth-oriented stage, will use those retained earnings to invest back into the business to help it grow. For example there might be research and development for new products, machinery and equipment, or perhaps growing the labor force.

When a company is in a more mature phase and has an established business then those additional earnings can be paid out to the shareholders in the form of dividends.

There are a few different types of dividends. Cash is the most common form although companies can also distribute dividends in the form of more shares of the company.

How Do Dividends Work?

Dividends don't just automatically become available after a certain time or stage in a companies existence. A company's board of directors make the decision as to whether and how much it will pay to shareholders.

Here are a few criteria as to how the board decides dividends:

Net income: The board assesses the company's net income, or what's left after expenses.

Future growth: The board considers how much capital should remain in the company to support future growth and operations.

Industry norms: The board considers what other companies in the industry are doing.

Once all of these factors have been considered then the board will approve a plan to share profits as dividends. Then the company will announce the dividend amount, payment date, and record date. Finally, the company pays the dividends to its shareholders.

Although it's a fairly straight forward process, there are a few very important dates to know, because they can determine whether you get a dividend or not.

Key dates to know:

Declaration date: When the board announces that the company will be paying a dividend. It will also disclose the amount, ex-dividend date, record date, and payment dates.

Ex-dividend date: This is a critical date that determines who qualifies to receive the dividend. In order to receive the dividend, an investor must purchase the stock no later than the day before the ex-dividend date.

Where does the name come from?

Before trading begins on the ex-dividend date, the share price is reduced by the exchange in the amount of the dividend. For example, suppose a stock that is trading for $50 per share declares a $0.50 dividend. On the ex-dividend date, the price adjusts to $49.50 ($50 minus the $0.50 dividend) for each share.

So in short, if you want to receive a dividend then make sure to buy the shares before the ex-dividend date.

Record date: This is simply the date the company officially records the stockholders who are eligible to receive the dividend.

Payment date: This is the date when the company pays the dividend and everybody rejoices.

For example, if a company pays a dividend of payment of $0.30 per share and an investor owns 10,000 shares, the dividend payment is $3,000.

Why Are Dividends Important for Investors?

The passive income benefits are one of the main attraction points for investors.

For shareholders, dividends are a way to benefit from a company's success without selling there shares. Dividends are also fairly predictable when it comes to frequency of payout. Usually companies pay dividends quarterly, monthly, or semiannually which makes it simpler to plan around.

Furthermore you can invest in companies with varying payout out schedules and actually stabilize your own income. For instance, say you're invested in a few companies that pay dividends quarterly but on different timelines.

You could structure a combination of investments in a way that you get a payout each month based on their different payment schedules. A great way to smooth out your income.

Compounding growth through reinvested dividends is the secret sauce of building wealth over time.

Yes, you could spend the money now but what would happen if you put that right back into buying more shares? Imagine that you didn't have to work any harder and your money is now doing the lifting for you.

Besides you're probably working full time anyways so why not let your money work for you. Then, when your portfolio has eventually grown over time it will be able to generate enough income to supplement your lifestyle AND be reinvested.

That's financial independence!

Also, they have HUGE tax advantages. Qualified dividends are taxed at 0%, 15%, or 20% depending on your taxable income and filing status.

Let's say you earn $100,000 as a single person. You'd fall into the 22% tax bracket on your earned income but your dividends would be taxed at only 15%. That's a huge deal. There a few requirements that need to be met and I'll explain that below.

The bottom line is that using dividend-paying stocks can help create stability and reliability in your portfolio.

How to Find Dividend-Paying Stocks

So this is all well and good but the question remains, how do you actually find dividend paying stocks and what should you be looking for?

Dividend yield is one of the most important things to consider if you're looking strictly at the bottom line. It's the amount of money a company pays shareholders for owning a share of stock.

The dividend yield is the amount of the annual dividend divided by price per share. For example, if a stock pays a $6 for the year and it's share price is $85 then the dividend yield would be 7%.

Keep in mind that a higher dividend yield doesn't always mean good investment opportunities. For instance a dividend yield might be higher as a result of declining stock price.

What's a good dividend yield? Glad you asked.

Typically yields ranging between 2% to 6% are considered by many to be attractive. Real estate investment trusts, master limited partnerships, and business development companies often pay higher than average dividends.

Always consider specific financial objectives when making a decision.

Aside from dividend yield it's important to take a holistic approach to assessing a companies financial health and ability to payout out consistently. Key financial metrics to check before investing include the level of debt to earnings and how liquid the company is overall.

Here are a few examples of well-known dividend-paying companies:

1. Johnson & Johnson
2. Chevron
3. General Dynamics
4. PepsiCo
5. NextEra Energy
6. Medtronic
7. Kimberly-Clark
8. Hormel Foods
9. Sysco
10. Target

Risks and Downsides of Dividend Investing

Dividend cuts happen when a company either completely stops paying out dividends or reduces the payout. Obviously this leads to sharp declines in stock price because it's now seen as poor reflection of the company's financial health and therefore less attractive.

Usually you'll see this when earnings are declining or the amount of debt is starting to pile up. There may be more positive reasons for a cut such as when preparing for a major acquisition or a stock buyback.

Tax implications of dividends should definitely be considered. There is a key difference in ordinary vs qualified dividends. A qualified dividend is the type that gets the preferential tax treatment mentioned earlier.

The requirements to be considered qualified are that the dividends are paid by a U.S corporation and the investor must have held the stock for more than 60 days during the 121-day period prior to the ex-dividend date (see I mentioned it was important).

If either of these requirements aren't met then it's now considered an ordinary dividend and all that means is that it's taxed as ordinary income based on your income tax bracket.

The last thing to keep in mind is the opportunity cost of choosing growth stocks vs. dividend stocks. Return on investment, regardless of what you invest in, is made up of appreciation in value, income, or a combination of both.

The very nature of dividend stocks is that they are more stable and mature businesses. This means that their stock price will most likely appreciate in value over the long run but it won't be exponential gains like a fast growing company.

How to Start Earning Dividends as a Beginner

Dividend stocks or funds can be held in either a brokerage account or an IRA. Selecting to reinvest dividends can also be setup to happen automatically or you can choose to do it manually.

Remember that, no matter the investment asset, building a diversified portfolio will always remain a core strategy. Spread your money across multiple companies and manage how much is allocated to each.

Dividends can be a fantastic way to generate passive income while growing your wealth over time. They can either be the core component of your strategy of working towards financial independence or a solid supplement.

By understanding how dividends work and selecting solid dividend-paying stocks, you can create a steady stream of income and financial security.

Explore different stocks, research their dividend history, and take your first step toward building long-term wealth.

Ready to start your dividend investing journey?