The internet is wildly obsessed with dividends.

I like dividends as much as the next investor. But most people misunderstand how they actually work.

Here’s what you need to know:

First, what are dividends?

A dividend is a cash payment to shareholders for holding a stock. It’s usually paid out monthly or quarterly.

Companies do not have to pay a dividend. In fact, many growth companies prefer to reinvest earnings back into the company instead.

So, why do companies pay dividends?

Companies typically pay dividends to:

• Signal financial strength and stability

• Reward shareholders for their investment

• Attract income-focused investors (e.g., retirees)

Mature, profitable companies like Coca-Cola $KO ( ▼ 0.31% ) , and Johnson & Johnson $JNJ ( ▼ 0.86% ) are more likely to pay dividends than a tech startup.

What is the dividend amount?

The dividend yield measures how much a company pays relative to its stock price.

Dividend Yield = (Annual Dividend / Stock Price) × 100  

But a higher yield isn’t always better. The stock price might be falling or the dividend might be unsustainable.

What is a payout ratio?

The payout ratio shows what % of earnings are paid as dividends to shareholders.

Payout Ratio = (Dividends Paid / Net Income) × 100 

A high payout ratio (>80%) can also mean the dividend is unsustainable, and the company might slash or suspend future dividends.

Dividends can be found on two of the four financial statements

• Statement of Shareholders’ Equity: Found under “Retained Earnings”

• Cash Flow Statement: Found under “Cash Flows from Financing Activities”

Some important dividend dates to know are:

• Declaration Date: Company announces the dividend

• Ex-Dividend Date: Buy before this date to qualify for the dividend

• Record Date: The date the company checks its books to see who gets paid

• Payment Date: The date the dividend is actually paid out

If you want to receive a dividend you have to own the stock before the ex-dividend date.

One thing investors forget is stock prices typically drop after dividends are paid. When a company pays a dividend, its value decreases by that amount—so the stock price usually drops accordingly.

Example:  

• Stock price: $100

• Dividend: $2 per share

• The stock price drops to $98 after the dividend is paid

This happens because the cash paid out as dividends is no longer part of the company’s assets.

Dividend Aristocrats and Kings

Companies that have a long track record of paying and increasing their dividend are known as dividend aristocrats and dividend kings.

• Dividend Aristocrats: S&P 500 companies that have increased dividends for 25+ years (e.g., Procter & Gamble $PG ( ▼ 0.71% ) , McDonald’s $MCD ( ▼ 0.66% ) ).

• Dividend Kings: Companies with 50+ years of dividend increases (e.g., Coca-Cola $KO ( ▼ 0.31% ) , Johnson & Johnson $JNJ ( ▼ 0.86% ) ).

Taxes

Receiving a divided causes a taxable event for the investor. There are two types of dividends:

• Qualified dividends: Taxed at lower capital gains rates (0%, 15%, or 20%)

• Ordinary dividends: Taxed as regular income

Dividends are classified as qualified or ordinary based on several factors, including:

• the type of corporation paying the dividend

• the holding period of the shares

• and whether the dividend meets specific criteria set by the IRS.

Holding dividend stocks in a tax-advantaged account (like an IRA) can help minimize taxes.

So, what should you do with your dividends?

The best strategy is to reinvest your dividends, which is also known as DRIP (Dividend Reinvestment Plans). When you DRIP your dividends, you automatically reinvest them into more shares instead of taking cash.

This allows you to compound your growth even further through dollar-cost averaging.

Wrapping up

Dividends can be a great source of passive income, but one thing investors get wrong is they’re not “free money” They come out of a company’s value.

The only thing that should matter to investors is total return.

Do you invest for dividends or growth? Reply and let me know.

—Darrell

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Its not a big ask, but it would mean a lot…

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