How Do Dividends Work?

In this episode we explore dividends. There are many layers to this topic such as types, distribution, and more. In this conversation explain the foundational concepts for those looking to learn more about dividends and potentially adding them to their investment strategy.

Summary – Cents of Security Podcasts Ep. 80

The following is a summary of a live audio recording and may contain errors in spelling or grammar. Although IBKR has edited for clarity no material changes have been made.

Cassidy Clement:

Welcome back to the Cents of Security Podcast. I’m Cassidy Clement, Senior Manager of SEO and Content at Interactive Brokers, and today I’m your host for the podcast. Our guest is Robert Reid, Senior Equity Analyst from Briefing.com. In this episode, we are going to explore dividends. There are many layers to this topic, such as types, distribution, and more. In this conversation, we look to explain the foundational concepts for those looking to learn more about dividends and potentially adding them to their investment strategy. Let’s get started. Welcome to the program, Robert.

Robert Reid:

Oh, thank you so much for having me.

Cassidy Clement:

Sure. So for our first question here, because it’s your first episode with us, why don’t you tell the listeners a little bit about your background in the industry and how you got started?

Robert Reid:

Sure. So, it’s funny actually, I started with a company called Salomon Smith Barney for Citigroup. On the sell side, we were doing research for steel companies. That’s kind of where I got my start , did that for about two years. I was also briefly on the buy side, and then probably the last close to 25 years now, I’ve been with Briefing.com doing equity analysis. Mostly, I focus more on fundamentals and buy and hold type investments. We do have like technical analysts, but my expertise is more on the,you know, digging into the fundamentals, looking at income statements, balance sheets, that kind of thing. So I’m more of a buy and hold type analyst. And just real quickly at Briefing, I’m in charge of the Emerging Growth Stocks Report, and we also publish a Value Leaders Report and a Yield Leaders Report too that I work on.

Cassidy Clement:

Cool. So just to get into the meat and potatoes, if you will, of the podcast. So we’re going to talk about dividends today. So when we’re starting out in the topic, what exactly is a dividend? Are there different kinds? Are they paid out certain ways?

Robert Reid:

So a dividend is basically a company rewarding its shareholders usually with cash. So for example, let’s say you have a stock trading at 100 a share. If it has a 3 percent yield, that means throughout that year, it’s paying about 3 percent of the value of the stock out in cash. Of course, the stock will go up or down over time so the yield will change from day to day but generally companies every quarter they’ll give out a cash payment to shareholders. It’s kind of just a way to allow investors to, you know, benefit from these investments without selling the stock.

So if they want to, you know, just throw off some cash to people and that way people can use this money to live on or maybe reinvest it in something else or reinvest in the company. They can do it that way. So just to kind of explain sort of the nuts and bolts a little bit so, you know, dividends are not required to be paid by a company, but a lot of times they do just because they attract people looking for an income yield and the way it works is let’s say there’s an ex dividend date And then the dividends usually paid out after that so usually if you own the stock before the ex dividend date, then you receive that quarters dividend but if you hold it on the ex date and beyond then you do not get paid the dividend. So that’s something to be careful of, people will need to keep an eye out for. So there’s cash dividends, there’s also stock dividends. A lot of times this happens when a company does a stock split. So if, you know, for example, Palo Alto Networks last week, they did a two for one stock split. So those shareholders got a stock dividend, when the stock split that they could just put into their portfolio. But for the most part, it’s cash dividends are the typical ones. And there’s also something called special dividends and these are sort of they’re not regular. A company will just give a special like let’s say if they’ve earned a lot of cash in a particular quarter, a particular six months, they might you know, give out a special dividend which is like a one time, you know, maybe a dollar a share .It’s usually larger than the typical quarterly cash dividends but it’s another way of rewarding investors, especially long term investors for buying and holding their stock. And again, the ex dividend date is something very important to keep an eye on especially for special dividends, which are larger. A lot of times you’ll see the stock drop on the ex dividend date because the value of the share of the security goes down once the dividend gets paid out.

Cassidy Clement:

Yeah, totally. I mean, there’s obviously different categories, I guess we can say that they go in and there’s a difference in, we’ll say the size or the timing of it. But when we talk about them in terms of special dividends, cash, stocks. Some people may initially think that sounds great why didn’t I get a dividend on X stock or B stock that I have? So, in a general sense, you know, do all stocks get a dividend and who decides if they even get them and why?

Robert Reid:

All stocks do not get a dividend. In fact, quite a lot of stocks do not. So the board of directors they decide, they do a vote on whether or not a company should be doing a dividend. So it’s usually up to the board of directors to make that decision. It’s basically companies that are geared more towards growth and they may not even be profitable, but companies that just want to grow, grow, grow, grow, grow, they tend to not even pay dividends. It’s generally like larger companies that generate a lot of cash, they want to just reward their long term shareholders with money. If you are looking for an income, make sure that you check the dividend to see if it’s something that you’re interested in.

Cassidy Clement:

So you had mentioned in the previous question talking about maybe the size or the one time only almost dividends and that kind of bleeds into, you know, are they growth? Are they value? How are they looking to apply this capital with their business to their holders? How exactly would taxes be applied to dividends? I mean, you don’t have to go into it like an accountant, but how would they be applied in a general sense?

Robert Reid:

What it really comes down to is how long you’ve owned a stock. So there are two types of dividends in terms for tax purposes. There’s qualified and non qualified. Qualified dividends have a lower tax rate, usually at zero or 15 or 20% but you have to hold the stock for 60 days before the ex dividend date, and I think 60 days after. So they’re generally more for longer term holders of the stock so you get that lower tax rate. For non qualified dividends you just pay the ordinary income tax rate. I think what the idea is there, they don’t want people like short term investors coming in two days before the ex dividend date, getting the dividend, and then selling the stock three days later.

So, they would receive that dividend, but they’re not long term holders of the stock. So the IRS doesn’t want to reward them with a lower tax bracket just because they come in for three days and buy the stock and leave. So that’s generally why they do that is for long term holders, they get the lower tax rate.

Cassidy Clement:

So initially, I guess people who are looking to incorporate dividends into their strategy, they may hear everything you’re saying and be like, well, generally it sounds great. I get some extra cash or items, if you will, in my portfolio, if they go stock. What would be the pros and cons to the argument of dividends? Like is it always considered a good thing or is it something that, you know, needs to be looked at with a critical eye?

Robert Reid:

I think it needs to be looked over the critical eye. I mean if you’re looking for a high growth investment then dividends are not really going to be that important. Dividends are more for if you want to hold a stock but you don’t have to sell the stock to generate some cash out of your investment. So it kind of depends what kind of you know, investment you’re looking at. If you’re looking for like a growth company or or even like a biotech stock they may not even earn any money. They’re probably not profitable, but you know, they might get you know, an FDA approval on some drug down the road. You’re not gonna get any dividends from that, but they might turn out to be a great investment if everything turns out well. And a lot of tech stocks, especially smaller ones, don’t pay a dividend. Again those companies, they take whatever money they do earn and they reinvest it back into the business. Maybe that means hiring more sales people. Maybe that means building out their data centers or trying to get more customers and they’re not as worried about paying shareholders. They know shareholders will be eventually be rewarded with the appreciation of the stock over the long term. So it just kind of depends what you’re looking for but a lot of people who do want that income, especially like older investors do where, you know, maybe they’re not working, but they want to collect some cash. They can look for a high income stock that won’t be as aggressive as a tech stock, for example, but it will, you know, spin off maybe 5, 6 percent every year and that’s good enough for a lot of people. Like a lot of utilities are attractive to those type of investors where the stock doesn’t really go up or down very much, but it does kick out, you know, a 5 to 7% dividend, which people can use without having to sell the stock and get hit with, you know, a capital gain. Just kind of depends what the investor’s looking for.

Cassidy Clement:

So let’s say somebody is looking to incorporate dividends into their financial strategy or dividend paying stocks into their portfolio. What are some things that they should keep in mind as they start to weave it in? I mean, are there ratios, are there various fields to pay attention to? Disadvantages? There’s so much research out there sometimes it’s hard to boil it down.

Robert Reid:

Yeah, it just kind of depends. What you’d like to do, especially if you’re a buy and hold investor. Basically you want a company that just consistently raises the dividend every single year. Then you know that dividend is safe and it generates good cash over time. But it generally just kind of depends what you’re looking for. If you’re more of a growth person, you probably should even just ignore dividends. But if you kind of want some of that income then it would be important to look at. Kind of a strategy that I like to do is kind of look for maybe beaten down names that are just kind of out of favor, but they pay a good dividend so the yield is very high. You know, for example, like a Whirlpool,. The housing market is kind of slow right now because nobody’s moving ’cause they don’t wanna give up their 3 percent mortgage, but eventually if rates do come down and let’s say people start moving again, they start selling their house, buying a new house, a stock like Whirlpool might be interesting because it pays about a 5.8 percent dividend. And it has that turnaround hopefully capital appreciation value as well. That’s kind of like threading the needle where you get both, where you get the nice dividend, plus you also get the hopefully capital appreciation. I like to look for beaten down markets or beaten down stocks that do pay a good dividend that turn themselves around when the market gets better. So those are the kind of things that that I look for.

Cassidy Clement:

So I guess my final question would be, you know, you had mentioned a few different labels kind of, for the stocks that we’ve been talking about in generalities, whether they’re growth or undervalued or we’ll say spreading profit. Is it kind of hard and true that the growth, type of companies aren’t really the ones to give out dividends? And you want to look towards more of the undervalued areas. I’m not sure if you could give any examples or if it’s just kind of whatever is happening in the market may impact these companies and they may not.

Robert Reid:

Yeah, it’s kind of a combination of all that I mean, it just kind of boils down to what you don’t kind of what people are looking for. I mean one other thing to kind of keep in mind here is what the Fed is doing with rates. Let’s say if the Fed keeps cutting rates, that actually makes some areas even more attractive. Let’s say utilities that generally have a good dividend. You know, if the Fed is going to cut rates, then that means just Treasuries are going to go lower. If you’re looking for that income, then that actually is good, not only for the dividends, but also for maybe some capital appreciation on high dividend areas. Like, utilities are good, financials tend to pay good, dividends, and yeah, it just kind of depends what you’re looking for.

Cassidy Clement:

Got it. Well, all of these points were really helpful. Thanks for joining us on the program today, Robert.

Robert Reid:

Okay, well, thank you so much. Have a good day.

Cassidy Clement:

Sure. So as always, listeners can learn more about an array of financial topics for free at interactivebrokers.com/campus. Follow us on your favorite podcast network and feel free to leave us a rating or review. Thanks for listening everyone.

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