What Is A Dividend?

Dividend investing is making a comeback especially in today's tough stock market. Dividends are now becoming important components of overall stock returns. But first...

What is a dividend?

The Basics

When companies make a profit, they have a few choices about what to do with the extra money. They could:

• Plow the money back into the business

• Expand by using the money to buy other businesses

• Pay down their debt

• Buy back some of their stock

• Pay out cash to their investors

This last option — cash paid out to investors — is called dividends.

The word "dividend" comes from the Latin word "dividendum" which means "the thing which is to be divided among all".

Some History

Until about 1950s, dividends were the way to go. People bought stock in a company mainly because of a its ability to pay dividends. In fact, dividends also made up a large proportion of people's retirement income.

With the advent of technology companies and the dizzying pace of technological growth, the focus of stock investing shifted toward capital appreciation. In other words, people started buying stocks primarily due to the potential for stock prices to appreciate. Dividends were left behind in the dust.

The tax disadvantage for dividends made it even worse. Cash dividends, for the most part, are taxed as regular income. Capital appreciation, on the other hand, is taxed only when stocks are sold. And if they are sold after owning them for a year, in the U.S. the gains are taxed at 15% (2010).

This is significantly lower than the tax rate on dividends if you are in the 25% and above tax bracket.

The bursting of the tech. bubble in 2000 brought investors back down to earth. The market downturn during our current recession that started in 2008 has had a sobering effect on the pursuit of wild capital appreciation.

Dividends are making a comeback in these unstable times. Investors are increasingly adding dividend stocks to their portfolios.

Types of Dividends

Dividends can be paid out in different forms:

• Cash — Cash is the most common form of dividend payments. The dividend rate multiplied by the number of shares owned by the investor gives the total cash amount that is paid out.

  The payment can be in the form of a check or an online deposit to your brokerage account.

• Stock — A company might decide to issue dividends in the form of additional shares in the company proportional to current ownership. So, say you own 100 shares in a company that declares a 2% dividend paid out in stock. This works out to an additional 2 shares of stock for you.

  Why would a company choose this form of dividend payment?

  A variety of reasons..... not enough cash on hand, an attempt to increase trading, tax reasons, etc.

  If the stock dividends are paid out by increasing the number of outstanding shares, the price automatically adjusts to keep the market capitalization (stock price x total number of outstanding shares) the same. This is similar to a "stock split".

• Property — Property dividends can take the form of goods and services like cocoa beans, gold, silver, automobiles or any other item with tangible value. While more common in the past, this form of dividend payment is very rare today.

• Other — Another form of dividend payment is through stock in subsidiary companies by large companies with several subsidiaries. Quite often, when a company spins off one its divisions into a new company, it grants shareholders of the parent company stocks in the new company. These stocks can be traded independently in the stock market.

In summary, we've answered the fundamental question ... "What is a Dividend"? We also looked at some recent history behind dividend investing and concluded our discussion by exploring the different forms of dividend payment.

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