dividend definition

Investing in Dividend Stocks: Know the Basic Definitions

I have written about picking up some dividend stocks recently. There are some tasty dividend yields out there. But before you do dive into dividend investing,  here are some basic definitions that will help you understand what is happening. 

Let’s start with some definitions:

1.) Dividend Yield 

The dividend yield is the amount that you will be paid if you held that stock for 12 months. It is expressed as a percentage rate of the stock price, and is similar to an interest rate that you would earn at a bank. Usually, the dividends are paid quarterly, but the yield is expressed as an annual yield. So if the Dividend Yield is 4%, then each quarter, you will receive a dividend of 1% of the value of the stock.

2.) Payout Ratio

The payout ratio is a measure that expresses how “safe” the dividend is. Remember companies have the option to increase or decrease the dividend. While it is rare that dividends are decreased, it usually hurts the stock holders in two ways. First, the dividend is decreased, so your investment is yielding less. Second, and perhaps worse, the stock price is going to be impacted negatively. No CEO wants to reduce a dividend rate, so unless they have extreme capital requirements (to pay back debt for instance), or if there business prospects are decreasing, they simply won’t. The market frowns on dividend decreases, and punishes the stock price.  The payout ratio is calculated by taking the Dividends per share and dividing it by the Earnings per share. It then measures what percent of earnings are taken up by paying dividends. It that ratio gets close to 1, then the company may be strapped to keep paying the dividend at the full rate.

3.) Dividend Reinvestment

Dividends can be paid in two ways. The first is that you receive money, usually delivered into your brokerage account. The brokerage account sweeps the money in, and deposits it usually in a money market account associated with your account. The other way is to automatically reinvest the dividend payment in additional stock. Rather than receiving cash, you receive more shares in that company. Why would you want that? First, it lets your investment grow. Now you are getting return from both the increased number of shares that you own, but if the share prices go up, you are getting double return! Second, it allows you to avoid paying taxes on your dividends. Deferring taxes is always a good deal. Important: you need to tell your brokerage which way you want to receive dividends. Many brokerages will assume that you want to reinvest, but definitely check on that.

4.) Ex-dividend date

This is the date that the shareholders of record will earn the dividend. Even though the dividend is paid out a couple of weeks later, if you owned the stock on the ex-dividend date, then you will receive the dividend.

5.) Indicated Annual Dividend

As I mentioned above, there are no guarantees that dividends will continue to be paid out at the same level. However, the Indicated Annual Dividend is the dividends that you would receive if the dividends paid in the next four quarters is paid at the same rate as the last dividend.

6.) Qualified Dividend vs. Nonqualified Dividends

Okay, this one is important. Receiving dividends will trigger a tax obligation, and you need to be aware of how much you might be having to pay. Essentially, if you are buying and holding the stock, and own it for more than 60 days during a 120 day window of 60 days before the ex-dividend date and 60 days afterwards, then it is qualified. Qualified dividends are taxed at a lower tax rate (depending on your tax bracket of 0% – 20%. Non qualified dividends are taxed at the capital gains rate. Now your head is probably spinning, and you are wondering how you are going to keep track of this. The answer is that you don’t have to, your brokerage will do it for you.

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