A dividend is a distribution of a portion of a company's earnings to holders of its stock. When a company makes money, it has the option to share that profit with its stockholders or retain that money as earnings, which it is then free to reinvest. If a company opts to pay dividends to its shareholders, they can be issued as cash payments, shares of stock, or other types of property.
When a company pays dividends, its board of directors decides what percentage of its earnings to distribute to shareholders. Though dividends are usually paid quarterly, a company that pays dividends is not required to do so every quarter.
When a company decides to distribute cash dividends, those who hold its stock receive payments based on the number of shares they own. Let's say you own 1,000 shares of a company's stock and that company's board of directors makes the decision to pay a cash dividend in the amount of $10 per share. Your payment would therefore be $10,000.
A company might decide to distribute stock dividends because it's low on operating cash but wants to make its investors happy. On the other hand, some companies disburse stock dividends because they offer investors more flexibility. A stock dividend isn't taxable until it is sold, whereas cash dividends are taxable immediately. For this reason, some investors prefer stock dividends to cash dividends.
Stock dividends work similarly to cash dividends in that each shareholder gets a certain number of additional shares based on the number of shares already held. Let's say you own 500 shares of a company and that company decides to issue a stock dividend of 5%. In that cash, you'd receive 25 extra shares of stock.
Why companies pay dividends
Sometimes companies retain so much net profit that they're able to reinvest in themselves and still have money left over. When this happens, a company might choose to issue dividends to its shareholders. Since many investors appreciate the extra income that dividends offer, distributing dividends could make a company's stock seem more appealing. Investors often see dividend payments as a sign that a company is thriving financially and anticipates continued earnings and as such are more likely to buy its stock. An uptick in investor interest can lead to increased demand, which can, in turn, cause a company's stock price to rise.
Why companies don't pay dividends
There are several reasons a company might choose not to pay dividends to its shareholders. If a company is still in the process of growing, it may opt not to pay dividends so that it can instead reinvest that money to fuel its growth. Even established companies might choose to skip dividend payments and instead put that money to better use, such as acquiring new assets or funding new initiatives to increase future profitability.
There are also tax implications that investors face when dividends are paid out. Dividends are taxed as ordinary income, which means that if you fall into the 30% tax bracket and receive a dividend payment, it will be taxed at 30%. On the other hand, if a company reinvests in itself and increases its value instead of paying dividends, its stock price will go up. You can then sell your stock for a price that's higher than what you initially paid for it, and as long as you've held that stock for over a year, you'll only be subject to a long-term capital gains tax which, for most taxpayers, is just 15% as of 2016.
Finally, once a company starts paying dividends, it can be difficult to stop, as some investors might view this shift as a sign of financial instability. If this happens, a company's stock price can fall, which is why some companies find it safer to avoid paying dividends in the first place.
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