What is a dividend?

article picture

If you’re a new investor, the idea of a dividend might not be at the forefront of your mind. But this payment can make a big difference in your portfolio, if you understand it properly. 

When we talk about how owning a share means being a part owner in a company, it can feel like an abstract concept. After all, unless you own most of the shares, you have no real decision power, and no other special privileges. 

But the dividend is one of those things where being a part owner of a company becomes much more real. As owner, you’re entitled to a portion of the company’s profits. The dividend is the way the company distributes those profits to the shareholders. Now, companies need a bit of their profits to keep the business running. So the executives usually declare a dividend at some point after the end of the fiscal year, which is paid out after shareholders vote to approve it. How much of the profits are passed down to shareholders is called the payout ratio. Let’s use an example to figure out how this works in real life. Let’s say Company X made 500 million in profit last year, and has 100 million shares outstanding. That means they made about 5 euros per share in profit. They decide on a payout ratio of 43%, which is relatively industry standard. That means they’ll declare a dividend of 2.15 euros. So if you own one share of the company, you’ll get 2.15 euros. If you own 100, you’ll get 215 euros, and so on.

How to make use of dividends 

There are different ways to use dividends. Some people like to take the money to spend. There are people who try to build up an investment portfolio large enough that they can live entirely off the dividends, though this requires a large upfront investment. 

The other option is to reinvest. That means they buy new shares of the company out of the proceeds of the dividend. This is a popular enough tactic that many trading platforms, brokers and funds allow you to do this automatically. When people talk about the return of a share over multiple years, they often include reinvested dividends in the calculation. 

It’s worth it to do some research on dividend-friendly stocks. Keep in mind that you’re getting paid for risk — the higher the dividend, the more risky the bet on the company is. But a good dividend can often make a nice difference for your portfolio. 

One last thing: keep an eye on the ex-dividend day. That’s the last day where a share can be bought to still receive that year’s dividend payment. After that day, the share price typically drops by the amount of the dividend. So if a share is trading at 50 euros, and has a 2 euro dividend, it generally should drop to 48 euros on the ex dividend day. This isn’t calculated as a share drop the way other drops might be — it’s simply the value of the dividend being taken out now that buyers can’t receive it anymore.