What are dividends and how do they work?

There’s something inherently cool about getting paid to invest.

When a company gives you a certain amount of cash per share that you own, that’s a dividend. For example, if you owned $1,000 of a stock and it paid a 3% dividend yield (more on this a bit), you’d get $30 a year just for owning it.

Not a bad deal!

Let’s dig in a bit to determine what are dividends and how do they work?

Technically speaking, dividends are a redistribution of a company’s earnings directly to its shareholders.

Let’s start with a snapshot of a company I’m sure you’ll recognize – Apple. If you directed yourself to Apple’s ticker page on Fool.com, you’d see the following information box:

Screen Shot 2015-05-19 at 4.40.18 PM

The immediate area your eyes should move to is Apple’s dividend and yield (abbreviated “Div & Yield” above).

In the case of Apple, each share of the company is worth $130.27, and the company will pay you $2.08 each year for every share you own.

So, if you owned 10 shares of Apple, you’d get $20.80 of dividends each year ($2.08 X 10 shares).

The yield is simply the amount the company pays each year, divided by its share price. In the case of Apple, that’s 1.6% ($2.08/$130.27).

What kind of dividends should you expect?

While dividends are great, the level of dividends different companies pay is vastly different.

Fast-growing Internet companies generally don’t pay dividends – and that’s not a bad thing.

With many of these companies seeing huge growth, they’re better off using profits to re-invest and grow their business.

However, for companies that are more mature and don’t have as much sales growth, keeping all their profits in the bank or pouring them back into a business doesn’t make much sense.

That’s why you’ll see larger, more recognizable brands like Wal-Mart, Coca-Cola, or JPMorgan paying dividend yields above the market average.

The dividend yields companies pay vary over time and market conditions. At the end of 2014, the majority of companies in the S&P 500 paid between 1% and 2%.

Bigger is not necessarily better

Wouldn’t investing be easier if you could just find the companies paying the biggest dividend yields, collect big paychecks, and live the remainder of your life in paradise?

Unfortunately, dividend payouts are much more complicated.

For example, you might see a company paying a mouth-watering 9% dividend.

So, if you owned $100,000 of it, you’d collect $9,000 each year.

Yet, the problem with high-payout stocks is that their dividends are often unsustainable.

Remember, dividends are paid through a company’s ability to pay out a portion of their profitability.

So a company paying a big dividend yield might be returning more money to shareholders than it profits in a year. That can only last so long.

And generally, when companies cut their dividend, the market does not greet the news positively…

So while companies paying large dividends might be attractive, you need to be able to assess how sustainable those dividends will be over time.

Other dividend considerations

There are a couple of things that you, the investor, need to be aware of concerning dividends.

  • Dividends are generally paid quarterly. There are exceptions like annual dividends and one-time special dividends. Yet, for the most part, companies try setting a rate that pays you once every quarter.
  • Dividends are taxable. If you bought the shares via a broker, that broker will send you a 1099 at year’s end telling you and the IRS how much you received during the year.

Click the link to get details about the key dates when it comes to dividends.

One of The Motley Fool’s subscription services, Income Investor, guides you in selecting dividend-producing stocks. Take a look at our 30-day trial offer to the newsletter here.

— Answer provided by Motley Fool member Chin Hui Leong and Fool analyst Eric Bleeker

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