Dividends: how they work and what to check
Dividends are the part of profits a company pays out to shareholders. How they're calculated, which dates matter and why a very high dividend isn't always a good sign.
When a company makes money it can do several things with it: reinvest it to grow, pay down debt, buy back its own shares or distribute it among its shareholders. That last part is the dividend. In the U.S. many companies pay every quarter; in Mexico it's usually once or twice a year.
Dividend yield
Dividend yield = annual dividend per share ÷ share price
The dates that matter
| Date | What happens |
|---|---|
| Announcement | The company announces how much it will pay and when |
| Ex-dividend date | From this day on, whoever buys the stock no longer gets that dividend |
| Record date | The company checks who its shareholders are |
| Payment date | The money reaches your account |
To receive the dividend you must own the stock before the ex-dividend date. On that day the stock price usually drops by roughly the dividend amount: the money leaves the company and lands in your pocket, so it's not a "free" gain.
The payout ratio
Payout ratio = dividend per share ÷ earnings per share
If a company earns $20 per share and pays $8, it pays out 40% of its profits. A moderate payout leaves room to maintain the dividend in bad years. If a company pays out more than it earns (a payout over 100%), it's using savings or debt to pay, and that can't last forever.
Why a very high dividend can be a warning
A 10% dividend yield may look attractive, but sometimes it's high because the price has already fallen a lot: the market expects the company to cut the dividend. This is called a "dividend trap". Before getting carried away by the percentage, check:
- That the company generates enough cash flow to pay it.
- Its history: has it kept or raised it for years, even in crises?
- Its debt: a heavily indebted company may have to cut it.
- Its payout: if it's very high, there's less margin.
Reinvesting dividends
If instead of spending your dividends you buy more shares, those shares will also pay dividends: compound interest applied to the stock market. Some brokers do it automatically (DRIP); with "accumulating" ETFs, the fund reinvests for you.
Taxes on dividends
In Mexico, individuals pay an additional 10% withholding on company dividends. For U.S. stocks, the U.S. also withholds 10% if you have the W-8BEN form (30% without it). We cover this in the taxes lesson.
Test what you learned
1. A $200 stock pays $6 a year. What is its dividend yield?
- 3%
- 6%
- 12%
Show the answer
3%. 6 ÷ 200 = 3%.
2. What happens if you buy the stock on the ex-dividend date?
- You get a double dividend
- You no longer get that dividend
- The company pays you earlier
Show the answer
You no longer get that dividend. You need to own it before that date.
3. A company pays more in dividends than it earns (130% payout). What does it suggest?
- That the dividend is very solid
- That it may not be able to sustain it
- Nothing important
Show the answer
That it may not be able to sustain it. It's paying with savings or debt.
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Everything in this section is educational: it explains how investing works, it doesn't tell you what to buy.