What Are Dividends? A Plain-English Explainer for First-Time Investors

Dividends are the part of a company’s profit that it pays out to the people who own its shares, usually in cash and usually on a regular schedule. Ask what are dividends on Investor.gov, the investor education site of the US SEC, and you get much the same definition.¹ Each payment is the company’s call, and FINRA, which oversees US brokers, puts it plainly: a company may pay dividends, but it does not have to.²

A dividend is not extra money on top of an investment’s return: FINRA counts the income an investment pays and the change in its value together, as total return.³ That idea explains why many successful companies pay nothing, why others buy back shares instead, and why a fund’s payouts are not a gift. In practice it comes down to three habits: compare holdings by total return, do not read a missing dividend as a warning sign, and check whether a fund pays its income out or keeps it. For where shares and funds fit in a first portfolio, start with these investing basics for beginners.

What are dividends? Profit the board chooses to share

Dividends are a company’s choice to hand part of its profit to shareholders rather than keep it. Investor.gov lists dividend payments among the reasons people buy stocks, next to capital appreciation, a rise in the share price.⁴

The choice exists because every profit has two possible homes. A dividend must be approved by the company’s board of directors before it is paid, and whatever the company does not pay out stays in the business as retained earnings, money it can reinvest.⁵ Think of a bakery that ends a good year with cash to spare: it can share the cash among its owners or buy a second oven. Either way the money belongs to the owners, as cash or as a bigger bakery.

Which buyer receives a payment depends on a short series of dates, set out with worked examples in our guide to how dividend income and its payout dates work, which also covers US and UK dividend tax.

How a dividend reaches you: cash, extra shares or a reinvestment plan

A dividend usually reaches you in one of three ways, and cash is the most common form; rarer payouts in other assets also exist.⁵ FINRA notes that you can either take that cash or reinvest it to buy more shares in the company.² Some companies pay in shares instead, and some run plans that turn each cash payment into new shares automatically.

1. 1The board declares a dividendfrom profit, for each share
2. 2Cashyours to spend or to reinvest
3. 3Extra sharesa stock dividend, in proportion to what you own
4. 4Reinvesteda plan uses the cash to buy more of the same shares

A stock dividend pays you in additional shares, either of the company itself or of a subsidiary it is spinning off.⁶ These payments, sometimes called scrip dividends, are usually made in proportion to what you own, so a 5 percent stock dividend gives the holder of 100 shares 5 more, and the company’s total market value does not change.⁵ The pie is cut into more slices, and each owner keeps the same share of it.

A dividend reinvestment plan (DRIP) lets you buy more shares of a stock you already own with each dividend. You sign an agreement with the company to join, and Investor.gov advises checking with the company or your broker whether the service carries a fee.⁴ Plans often charge no commission and sometimes buy at a slight discount; in most cases, reinvested dividends are still taxed, so check your own country’s rules.⁵

Taking the cash or reinvesting it does not change what your holding is worth on the day. The choice decides whether the money keeps working inside the investment or moves into your spending.

Is a dividend extra return, or part of it?

A dividend belongs inside your return rather than being added to it, because the cash a company pays out is cash it no longer holds. Total return, the yardstick FINRA uses, combines the rise or fall in an investment’s value with every payment it made, and FINRA calls this combined figure generally the most accurate way to judge how an investment did.³

The share price shows the trade-off. FINRA notes that a share’s price may fall by the amount of a cash dividend on the ex-dividend date.⁷ That is the day from which, Investor.gov explains, new buyers no longer receive the next payment, a step the dividend income guide above walks through.⁶ Prices move for other reasons too, so the drop is rarely exact.

Economic theory reaches the same place. The Modigliani-Miller theorem, named for the economists Franco Modigliani and Merton Miller, holds that in an idealized market, with no taxes, no bankruptcy or agency costs and no information gaps, a company’s value does not depend on its dividend policy.⁸ Real markets have taxes and costs, but the starting point holds: a payout shifts value from the company to you.

1. A company that pays a dividend: part of the return arrives as cash, the rest as a change in the share price
2. A company that pays none: it keeps the cash in the business, so any return comes through the share price. Judge both by total return

A worked example, hypothetical and before tax and costs: two holdings each start the year worth US$1,000. One pays US$30 in dividends and its price rises by US$40; the other pays nothing and its price rises by US$70. Both owners end the year US$70 better off.

Many investors still keep the halves apart in their heads. In the abstract of a 2019 Journal of Finance article, Samuel Hartzmark and David Solomon describe individuals, mutual funds and institutions trading as though dividends and capital gains were unrelated, not fully appreciating that a payout lowers the price. They also tie stronger demand for dividends, in times of low interest rates and weak markets, to lower returns for the shares that pay them.⁹

Myth

A dividend is a bonus paid on top of what the share earns.

Fact

It is part of what the share earns. The cash leaves the company, and on the ex-dividend date the share price may fall by about the payout, so the owner gains cash but holds a share worth less.

Compare investments by total return, and when a share’s high payout tempts you, ask what happened to its price over the same years.

Do all stocks pay dividends?

Not all stocks pay dividends, and many successful ones never have. Investor.gov’s own examples draw the line: a start-up tech firm, its picture of a growth stock, rarely pays one; an established utility, its picture of an income stock, pays steadily; and penny stocks pay none.⁴

The study

Moderate evidence

Fama and French on the companies that stopped paying

Eugene Fama and Kenneth French tracked US companies listed on the New York, American and Nasdaq exchanges, leaving out financial firms and utilities. Once Nasdaq companies joined the data in 1973, the share paying cash dividends rose to a peak of 66.5 percent in 1978, then fell to 20.8 percent by 1999. Part of the drop came from a flood of new listings of small, less profitable companies with strong growth prospects, the kind that have never paid. But companies of every type also became less likely to pay.¹⁰

The finding is a count of companies, not of money. Harry DeAngelo, Linda DeAngelo and Douglas Skinner showed in 2004 that total dividends paid by US industrial companies, after inflation, rose over the same decades: the payers that dropped out had paid very little, while the biggest payers paid more.¹¹ Dividends became concentrated in a small group of big, highly profitable companies.

Other large economies show a similar picture. David Denis and Igor Osobov studied the US, Canada, the UK, Germany, France and Japan from 1989 to 2002 and found that payers tended to be larger, more profitable companies built largely on profits kept over the years, and that in every one of the six countries total dividends had not shrunk. Their results support a life-cycle view, in which a young company has more good uses for money than it generates, while a mature one earns more than it can usefully invest and pays the surplus out.¹²

A new software firm and a decades-old water utility are at different stages of that cycle. So when a share you are looking at pays nothing, ask where the company is in its life and what it is doing with the profit it keeps.

Why do some companies buy back shares instead of paying dividends?

Some companies return cash by buying back their own shares, an alternative to paying dividends. A share repurchase, or buyback, reduces the number of shares held by the public, so even if profits stay the same, the earnings per share rise.¹³

A hypothetical example shows why owners can gain without receiving anything. A company is owned in 100 equal slices, one of them yours. If it uses spare cash to buy back 5 slices from owners who want to sell, the business now has 95 slices, and yours has grown from one hundredth to one ninety-fifth of the company. Shareholders who sell get cash; those who stay own a bigger piece.

Managers like buybacks for their flexibility. In a 2002 survey of 384 finance executives recruited in the US, plus interviews with 23 more, Alon Brav and three co-authors heard that keeping the dividend steady ranks with investment decisions, while buybacks come from whatever cash is left after investing; many said they favor buybacks because they see them as more flexible than a dividend.¹⁴

Over time, US companies shifted toward that route. Gustavo Grullon and Roni Michaely reported in 2002 that firms had gradually substituted repurchases for dividends, and that buybacks had become the preferred way for a company to start paying out cash.¹⁵ Fama and French found, though, that buybacks were mostly carried out by companies that already paid dividends, adding to their payouts rather than replacing them.¹⁰

Buybacks have critics. Part of executives’ pay may be tied to share-price or earnings-per-share targets that a buyback can lift, and the tax treatment of buybacks and dividends differs between countries; in some, a buyback lets owners defer tax until they sell and pay it as capital gainscapital gains: The profit from selling an asset, such as shares, for more than you paid; a sale for less is a capital loss. Whether and how gains are taxed, and how losses can offset them, depends on the country and the kind of account.Full entry in the glossary instead.¹³

When you compare companies, count both routes. A company paying a small dividend may be returning far more through buybacks, and neither route says anything on its own about whether the business is doing well.

How funds pass dividends on to you

A fund collects the dividends of every company it holds and passes them on. Investor.gov explains that a mutual fund earns income from its portfolio, such as dividends on stocks or interest on bonds, and pays its shareholders nearly all of that income, less expenses, as a dividend payment. Funds usually let you choose between receiving the cash and reinvesting it in more fund shares.¹⁶

An index fund sold as a mutual fund works the same way: the dividends of the companies on its list flow into the fund, and from the fund to you. Some funds make the choice for you. In the UK, the FCA’s rulebook defines an accumulation unit as one whose income is credited periodically to the fund’s capital, so the payout is folded back into the fund’s value instead of being paid out.¹⁷ Other countries use other labels for the same split between paying out and reinvesting.

So two people can own the same fund and see different things: one receives small cash payments, the other sees each unit’s value rise by the income kept inside. Before costs and tax, neither is richer for it.

Checks to run on any dividend pitch

Nothing here recommends a stock or a fund, and an offer built around a high or promised dividend deserves extra care, because no ordinary share promises one. Three checks help before you act:

• Check the seller. According to Investor.gov, much of the investment fraud in the US is committed by sellers with no license or registration, and the site’s lookup shows whether someone is licensed.¹⁸ For a UK firm, the FCA’s Firm Checker confirms whether it holds permission to sell you that product or service; because fraudsters sometimes pose as a genuine firm, the FCA also advises checking that the contact details you were given match the Firm Checker’s.¹⁹ Elsewhere, look the seller up on the register your country’s financial regulator keeps.
• Read the payout as part of total return, and look at the price history alongside it.
• For a decision that depends on your taxes, income or debts, a regulated financial adviser or your tax authority’s guidance can answer what an explainer cannot; ask advisers how they are paid.

The bottom line

A dividend is a company handing part of its profit to its owners, and it is part of your return. Judge any share or fund by its total return, check whether a fund pays out or reinvests, and treat no dividend as promised.