Stock dividends: Seem like free money, but it’s a bit more complicated

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Slicing up earnings and allocating them to the owners.

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A stock dividend is a regular payment you receive simply for owning shares of a certain company. In a way, it’s like earning cash for doing almost nothing, but like most aspects of money and investing, it’s more complicated than that.

Hundreds of companies pay dividends, and millions of investors collect dividend checks (or digital deposits) every year. Companies pay dividends to attract and keep investors, and investors use dividends to buy groceries, pay down debt, or take vacations. Some people reinvest their dividends, meaning they use the proceeds to purchase additional shares and grow their portfolios.

Dividends might feel like free money, but they’re not. They’re paid out of a company’s earnings, which means a dividend reduces the company’s ability to fund future investment—including research, equipment upgrades, development of new products, and employee compensation. Dividends might be fun to receive, but earnings growth and exciting new products are what often propel a stock higher.

A dividend is a set amount of money that some companies pay out of their profits to each shareholder, usually quarterly, and in cash (local currency, in the form of a check or digital deposit to your investment account). Occasionally, a company will pay a dividend with stock, but the vast majority of common stock dividends are distributed as cash.

When a company pays a dividend, that reduces the amount of retained (post-dividend) earnings. Also, a dividend announcement only helps people who already own the stock, so it might make the stock temporarily less attractive to potential new buyers (the dividend reduces not only retained earnings, but also the company’s cash on hand).

For example, suppose shares of XYZ are trading for $50 and there are a billion outstanding shares. Last quarter it earned $2 per share (or $2 billion), and it announced a dividend of $0.50 per share. After the dividend, all else equal, the shares would trade for $49.50, and XYZ’s retained earnings would be reduced by ($0.50 x 1 billion) = $500 million. While XYZ’s cash position would be reduced by $500 million, XYZ shareholders would, collectively, hold $500 million more in cash.

Let’s look at an example. As of mid-2022, shares of Apple (AAPL) were trading for $155, and the company paid a 23-cent per-share quarterly dividend. That means for each share you own, Apple would cut you a 23-cent check each quarter. If you owned 100 shares, you’d expect $23 ($0.23 multiplied by 100) each quarter, or around $92 a year.

Arguably, $92 doesn’t seem like much of a payoff for risking more than $15,500 (100 shares multiplied by $155 a share). But Apple’s dividend is relatively low by stock market standards. Some stocks pay much higher dividends, and if you own enough dividend stocks, the total combined payment can be significant.

It’s worth noting, however, that dividends aren’t guaranteed. A company may choose to raise, lower, or even eliminate its dividend program at any time.

Sometimes you’ll hear dividends referred to as “yield” on a stock. Calculating dividend yield is one way to determine whether a stock’s dividend is generous or only fair, and to compare it with dividends from competing stocks.

To calculate dividend yield, take the annual dividend per share (with Apple, it’s $0.92, or the quarterly 23-cent per share yield multiplied by four), and divide that by the price per share ($0.92 divided by $155 for Apple in mid-2022). That works out to a 0.59% yield.

In the world of dividend yields, 0.59% is low. Energy giant ExxonMobil (XOM) sports a dividend yield of about 4%. Its quarterly dividend as of mid-2022 is $0.88, or $3.52 per share per year. At the mid-2022 share price of $90, the yield would be ($3.52 ÷ 90) = 3.9%.

Dividend yields fluctuate with the price of the stock. If ExxonMobil’s share price were to rise to $95, and the dividend didn’t change, the yield would fall to ($3.52 ÷ 95) = 3.7%. If shares fell to $50, the dividend yield would rise quite a bit, to ($3.52 ÷ 50) = 7.04%, but that wouldn’t necessarily be good news.

Sure, it’s a high yield, for the time being. But when a company’s share price declines rapidly—particularly if it’s prompted by a fall in profitability—a dividend cut may be imminent. And if you were an existing investor, the fall in share price would be hard to swallow, despite the higher dividend yield.

Packing a portfolio with high dividend payers might seem like easy money, but that’s not necessarily true. Remember: the yield goes up as the stock price goes down. So a high yield should alert you to check the stock’s chart and see if it’s fallen a lot recently. Then find out why.

It might seem more logical for a company to keep its profits and plow them back into growing the business. But it’s also important to attract new investors and keep current ones. If the stock price doesn’t climb much—either because the company’s growth is slow or it’s lost ground in a competitive industry—it can spend part of its profits on dividends, keeping current investors happy and perhaps attracting new investors who seek income.

A seasoned company with big profits may face pressure from investors to initiate a dividend if the stock is in a rut. Or a company might be doing well and generating so much cash that it comes under pressure to pay shareholders some of the money.

The percentage of profits a company pays in dividends varies. Remember, the bigger the percentage, the less the company can invest in future growth. When Apple reported quarterly earnings of $1.20 a share in mid-2022, it planned a 23-cent dividend, or roughly 19% of quarterly earnings. That 19% is called the dividend payout ratio.

Meanwhile, for the same quarter, construction equipment maker Caterpillar (CAT) earned $2.88 a share and paid $1.11 per share in dividends. That means CAT spent roughly 38% of its quarterly profit on dividends.

Does this make CAT a better stock to buy than Apple? Not necessarily, because it could mean there’s less growth potential for CAT—or fewer alternative uses for its cash on hand.

Should dividend payers be part of your portfolio, and what percentage? A lot depends on knowing your investment goals—whether you’re targeting income or long-term growth, for example—and understanding your risk tolerance. A high dividend yield might look like free money. But it might also be a warning sign that a company’s fortunes are fading, and future dividends could be reduced or eliminated.

When you invest in a company’s stock, you’re buying a share of its future profit. Those profits may be returned to shareholders via periodic dividends or retained by the company to fund its current and future operations.