Investment Glossary – Dividend
This article is going to be one that really pays dividends for you down the line. Well, it won’t actually pay dividends, but it will…well, you know, it’ll be useful for you at some point in the future.
So what exactly is a “dividend” anyways? When I was a kid, I used to play a game called Railroad Tycoon II. The goal of it was to build a massive railway empire, competing with all of the major historical players in the railroad business. In hindsight, the game actually contained a pretty robust economic engine, allowing players to open up new routes, forecast supply and demand for different goods, buy and sell stocks, and yes, issue dividends from your own company. As I said, it was pretty robust. In fact, it was too robust for my 12-year-old brain to handle, as I loved trying to personally make myself as much money as possible by maximizing the dividend that my company issued, only to find that we were out of business within a couple years. And I had no idea why that happened.
Here is why it happened.
A dividend is a portion of a company’s earnings that the company’s board of directors decides to pay out to holders of its common stock. A dividend is not guaranteed, and it can be changed from quarter to quarter at the board’s discretion (though it does have to be approved by a majority of shareholders, who typically don’t put up much fight as long as the board makes them money). Dividends are typically issued on a quarterly basis, though companies may also issue one-time “special dividends.” These are typically declared only if there is a one-time event that results in a windfall to the company that they’d like to pay a portion of to shareholders.
Companies are not required to issue dividends and in fact, many companies do not pay any dividends at all. In particular, early-stage companies that need to reinvest heavily into their business typically will not issue any dividends. It is usually the more mature, stable companies that tend to pay them. While dividends are not guaranteed, most companies that issue them try to do so in a way that allows them to continue to pay the dividend or increase it over time since this can be an indication to outside investors that the company is stable and potentially offers a consistent way for investors to generate income for their portfolio. On the other hand, cutting a dividend can have significant negative effects on a company’s stock price. This sometimes happens when investors who once bought the company for its dividend become more likely to leave, and it may also signal further trouble with the company since it is effectively signaling that it needs that capital in order to enhance its prospects for survival.
There are a few dates that you need to be aware of when it comes to dividends since a company doesn’t just declare a dividend and pay it out immediately. The first date to be aware of is a dividend announcement date. This is simply the date that a company announces their upcoming quarterly dividend. The next major date in the cycle is the ex-dividend date, or “ex-date” for short. The ex-date is a fancy way of saying that if you want to collect the dividend, you have to own the stock prior to that date or else you can’t collect anything. Next in line is the record date, which is the date that a company records who actually owned the stock prior to the ex-date. This is largely a relic caused by how equity markets work, as it typically takes two business days for equity trades to settle. Lastly, we have the payment date, which is the date that companies actually make the payment to holders who held the stock prior to the ex-date. In simpler terms, it’s when you actually get paid your dividend.
So to pull this train full circle, I bankrupted my companies in Railroad Tycoon II by paying out dividends that were too big for my companies to support. A key piece of analysis that you have to do on companies that pay dividends is figuring out if they are doing the same thing I did, or if they are actually using practices that likely allow them to continue to pay that dividend or increase it in the future. Dividends can be a great source of income for investors, either before or during retirement, but their non-guaranteed nature means that in addition to asking what you own when you own a stock, you have to ask what you own when it comes to a dividend.