A dividend is a sort of financial incentive that a company distributes to its shareholders. There are several types of dividends that companies pay out: extraordinary dividends, stock dividends and cash dividends.
A company's dividend is determined by its board of directors and requires shareholder approval. However, company's don't have to distribute dividends. In a nutshell, a dividend is nothing more than a portion of a company's profits that it shares with its shareholders.
After paying off its debts (including salaries, rent, suppliers, etc.), a company can use some or all of its residual profits to reward its shareholders in the form of dividends. However, if the company prefers to use its cash to invest in factories, or R&D, for example, it can simply skip the payment of dividends.
If a company's board of directors elects to give shareholders previously held cash, then it is an extraordinary cash dividend (which is taxable). Companies distribute these types of dividends in order to avoid future tax increases.
A stock dividend, on the other hand, is a payment to shareholders made in the form of additional shares.
Earning stock dividends is one way to reinvest in a company. If the company's value increases over time, so does your dividend (which is now additional stock). In addition, this type of dividend isn't taxable as long as the shareholder doesn't sell it. This is also beneficial in that you can avoid broker commissions.
In addition, as this is essentially reinvesting in the company, it sends a signal to the market that says the company is doing great, thereby increasing its symbolic value, which can eventually lead to a rise in the stock price.
As for cash dividends, they are money distributed to shareholders from a company's profits. It is the most common way of sharing a company's profits. It allows shareholders to benefit from steady income and a dividend reinvestment plan.
Although cash dividends are the most common, there are yet more varieties that exist:
If you're a shareholder, you're entitled to a share of the company's profits. Alternately, you have the right to be paid a dividend.
If you're an investor who prefers liquid holdings, you have two options. The first is to have the money deposited right into your bank account. The second is to reinvest the dividend by purchasing shares of the company issuing the dividend. This is called a dividend reinvestment plan. The first option generates immediate income, while the second one is better in the long run.
Or, you may elect to receive stock dividends.
Example: Suppose the "X" company makes a £2 million profit in the first quarter. If a shareholder owns 5,000 shares of a company valued at £10 per share, and the company distributes a 5% stock dividend, the shareholder will receive 100 new shares as a dividend.
The yield represents the yearly income that a stock earns. It is expressed as a percentage - it's the ratio of the amount of the dividend divided by the current stock price.
If a dividend remains the same each year while the price of each share increases, the yield decreases, and vice versa if the price decreases.
The return is 0% for companies that decide not to issue a dividend.
The yield is therefore important, but it doesn't take into account potential capital gains. Many investors, such as myself, really only care about a stock's capital gain potential - and they can make a lot of money if they time their stock buying during recessionary periods.
Should you focus on high yielding stocks?
No! Choosing a stock market investment shouldn't be based solely on dividend yields. It is also necessary to assess the stock price's evolution in relation to the dividend payouts over long-term time horizons.
The ideal is to have both a good dividend yield rate and a good price gain performance.
Even though cash dividends are the preferred option, stock dividends have their fans. First of all, stock dividends cannot be taxed! Furthermore, this option gives investors flexibility: you can sell your shares when you receive them and receive cash.
If you want, you can hold your stock dividends and invest in the future of the company. Above all, this is a sign for the market, indicating that the business is healthy and profitable. This could eventually lead to an increase in the price of the company's shares, and thus your portfolio value.
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