A dividend is a payment of something (usually money but sometimes stock) by a company to its stockholders on a per-share basis. In most cases, dividends are paid out of the profits of the company. Most companies pay dividends on a quarterly basis, but some pay quarterly, semi-annually or annually. Many companies do not pay a dividend at all, or they may occasionally pay a “special dividend”, which just means that the dividend is not paid on a regular basis. We typically associate dividends as payments by a corporation to its stockholders, but partnerships, LLCs and trusts can all make payments to their owners that have names such as “distributions” or “returns of capital”. In some cases, those distributions and returns of capital are the same as dividends from a tax standpoint, but in others they are treated very differently. I will explain the differences in my next article.
There are four dates attached to the payment of a dividend. The most important date is the “ex-dividend date”, which is when the stock price in theory drops by the amount of the dividend and the date when it is determined who owns the stock for purposes of receiving the dividend. If someone buys stock on or after its ex-dividend date, then the seller gets the upcoming dividend and not the buyer. The other important date is the “payable date”, which is simply when the dividend is paid to the stockholders who owned the stock on the ex-dividend date, even if they sold their stock in between the ex-dividend date and the payable date. The other two dates are the “declaration date” and the “record date”, with the former being when the company announces the upcoming dividend payment and the latter being when stockholders need to be the owners of record of the stock, although the record date is tied to the ex-dividend date, which is the key date of the two.
The biggest disadvantage of a dividend is its tax treatment. When a company earns a profit, it pays tax on that profit. When it distributes some of that profit to its stockholders in the form of a dividend, the stockholders must then pay tax on that dividend, meaning it is taxed twice. If you have a tax-advantaged account such as a 401(k), IRA, Roth IRA or HSA, then you can defer or possibly avoid that second tax. Another disadvantage is that once a dividend is paid, the company no longer has that money available for other uses, such as paying down debt, purchasing assets, buying other companies, or investing in research and development. Many people believe that a company can provide the best returns to its stockholders by reinvesting those profits to earn even more profits in the future, rather than paying those profits to stockholders.
There are many opinions on this, but to me the biggest advantage of a dividend is that it is the only way you can get a return on your investment without selling the stock. The price of the stock can vary, sometimes tremendously, and there is no guarantee that the stock can be sold at a profit when you want to sell it, but at least with a dividend the stockholder gets some money back. Dividends made up 43% of the total return of the S&P 500 over the past 85 years, and companies that have paid a dividend have historically provided greater overall returns than companies that did not pay a dividend or that stopped paying a dividend.
Another advantage of paying dividends is that it forces companies to be disciplined in how they spend their money. In short, a company that is committed to paying a dividend each quarter has to be more discerning with their profits, so it cannot afford to make as many unwise acquisitions or research and development investments. I will discuss this in more detail in a future article, but companies are in the aggregate pretty poor at reinvesting their profits, so forcing them to only make the best choices with their money by virtue of having some of their profits committed to dividends may actually be a good thing.
Dividends also provide an opportunity for stockholders to compound their returns by reinvesting the dividends into more stock. Many companies pride themselves in paying a dividend on a regular basis, and in increasing the dividend every year. If you take the dividend and use it to buy more stock, then you will get an even greater dividend payment the next quarter, so between the quarterly dividends and the annual dividend increase, with many companies you can compound your return five times a year. For a real world example, consider that $1 invested in the S&P 500 in 1912 became $152 by the end of 2012, which is not bad, but if you took the dividends over that time period and reinvested them in more shares of the S&P 500, then that $1 would turn into $9,465 (source: The Morningstar Guide to Dividend Investing by Josh Peters, CFA).
I believe it is important for physicians to understand stocks, bonds and other investments so that they can either make investment decisions on their own or have a BS buzzer in place to determine whether their adviser is making good investment decisions. Dividends are one of the most integral parts of understanding stocks, and I will expand on this over many more articles to come.