What Are Dividends and How Do They Work?

If you’ve been involved in investing for a while, you’ll already be familiar with the term dividends.

But if you are new to investing or find yourself feeling a little overwhelmed – then this article is for you!

In this blog, you will get to know more about dividends and how you can use them in your financial planning. But first, what is a dividend, anyway?

What is a Dividend?

A dividend is a distribution of a portion of a company’s earnings to its shareholders.

When a company earns a profit or surplus, the board can use that profit to reinvest in the business, distribute it to shareholders through a dividend, or purchase its own shares.

A company’s board of directors decides whether and when to pay dividends on common stock. The board makes this decision because they are acting in the best interest of shareholders, who are their owners. They want to take actions that will increase the value of their investment in the long run.

Dividends can be paid in cash or maybe distributed as additional shares. Dividends are usually declared once or twice a year and paid for one or more quarters after each declaration date.

Types of Dividends:

There are many types of dividends, but the most common is the cash dividend. Let us see the various types of dividends paid by the companies.

• Cash Dividends: Cash dividends are the most common form of dividend and are paid directly to stockholders. You will be paid in cash, usually by electronic transfer.
• Stock Dividends: Stock dividends are paid in company shares instead of cash. You will be paid in the form of additional shares rather than cash payments.
• Special Dividend: A special dividend is an extra payment made to shareholders by a company that’s not part of the normal dividend cycle. Special dividends often occur as a result of corporate restructuring or other factors that change management’s view about the prospects of the business.
• Dividend Reinvestment Plans (DRIPs): DRIPs are programs through which you can reinvest your cash dividends into more shares of the issuing company itself. 

How is the ex-dividend date different from the record date?

The ex-dividend date and the record date are two dates that are important to stockholders. 

The ex-dividend date is the date on which a company declares that it will no longer pay dividends to shareholders who buy shares after that date. 

The record date is the date on which a company’s board of directors establishes who owns shares at a certain point in time, so all dividend payments will go to those people.

Confusion between the record date and the ex-dividend date is common. The former is set by a company, and the latter by a stock exchange. This is because there is a settlement period for trades made at exchanges.

Why buy dividend stocks?

Well, there are some real benefits to holding shares in companies that generate income for you as a shareholder. Dividend payments can signal a healthy company.

If you want to know if a company is doing well, one quick way is to look at its dividend payments. If the company is paying out dividends, it means it has enough money to cover the payments and still operate. 

Dividend stocks can provide a nice cushion against market volatility. The additional income can help offset potential losses during down cycles or make it easy to reinvest in other opportunities.

Dividends are a great source of passive income. The best part about dividend stocks is that they can provide an income stream—even when you’re not actively trading on the stock market.

If you buy shares of companies that consistently pay dividends and then hold on to them for many years, you can start getting paid without having to do any work at all!

Why Do Companies Pay Dividends

Companies pay dividends because they want to reward their shareholders and encourage them to invest in the company. Dividends are often used as an incentive for investors to hold on to shares, rather than sell them on the stock market.

Dividend payments can also help to reduce the cost of financing a company’s activities and operations.

When companies pay dividends, they are giving away money that could have been used for other purposes. However, dividends can help improve a company’s financial performance by increasing its share price and making it more attractive to investors.

Companies may be able to increase their dividend payments if their profits grow or if the share price increases significantly.

How to evaluate Dividends?

When evaluating a dividend, the first thing to consider is how sustainable it is. Companies that pay consistent dividends over time are likely doing so because they have a sustainable business model and can generate enough cash flow to support those payments.

In general, the higher a dividend is, the more valuable the stock is. However, there are several ways you can evaluate dividends.

• Dividend coverage ratio: This ratio measures how much money a company has on hand after expenses and interest payments. It shows what percentage of earnings per share (EPS) are being paid out as dividends. The higher this percentage is, the safer the dividend appears to be.
• Payout ratio: This compares how much earnings were paid out in dividends during one year versus how much was reinvested back into operations or used for other purposes like share buybacks or acquisitions. A high payout ratio means more earnings are being paid out in dividends than reinvested into operations or used for other purposes. The higher this number is, the more likely it is that the company will have difficulty paying future dividends.
• Dividend Growth Rate: The dividend growth rate measures how quickly a company increases its dividend payments over time. A growing dividend giver assures investors that they can rely on their income stream from returns on their investment.
• Dividend Yield: Dividend yield is calculated by dividing the annual dividend per share by the current price of the stock. For example, if a stock has an annual dividend of Rs 2 per share and its current price is Rs 40 per share, then its yield would be 5%.  The higher the dividend yield, the better, since it indicates that investors are being compensated for their risk in holding a given stock. In some cases, companies that pay out large dividends may not be growing their businesses quickly enough or generating enough cash flow to maintain those dividends over time. This can be a red flag for investors who want companies that will offer continued growth potential without sacrificing current cash flow generation.

Income Tax on Dividend Income in India

Dividends are a part of the income of an individual or company. If a company pays dividends to its shareholders, then shareholders will have to pay tax on it. The amount of dividend received by the shareholder is added to his total income and taxed according to his slab rate.

As per the Finance Act, 2020, if you get dividends from an Indian company or a mutual fund of over Rs 5,000 in a year, the company will deduct tax from it at 10%.

The amount of tax deducted will be shown on your dividend certificate, and credit for this amount will be given to you while filling out your income tax return. You’ll have to pay taxes later based on your income for that financial year when you file your income tax return.

To summarize, there are undoubtedly many reasons to be optimistic and excited about dividend investing, especially as technology continues to make these investments simpler and more accessible.

While you have to be willing to do your share of research and learn a little bit about the market, it’s not too tough to get started. If you’re at all interested in passive income streams and building wealth over the long term, then it’s worth looking into.

At the very least, reviewing the list above should give you a good idea of what dividend stocks even are, how they work, and which ones could end up being viable investment targets for you.