A stock company can decide to pay dividends to its owners. For most stock companies and in most jurisdictions, paying dividends is suggested by the board but will only take place if approved by the shareholders. Paying dividends can for instance be a way for the company to pay its owners after a profitable year.
Owning stock in a company that pays dividends means getting a revenue from the shares without having to sell them. Investors who actively look for companies with a long history of strong dividend payments are often investors that wish to purchase stock with the intent of holding on to the shares for a long time. They want regular revenue from their shares – instead of buying shares, waiting for the share price to rise, and then sell the shares to realize a profit.
Stock dividends are usually paid in cash, but they can be paid in almost any form. A company can for instance decide to distribute physical property to its shareholders.
Favorable tax treatment
In many jurisdictions, income from dividends receive favorable tax treatment. It is not uncommon for dividend income to be taxed differently than a profit made from selling stocks. Tax planning can be a strong incentive for investors to invest in companies known for their large and regular dividend payments, especially if receiving this type of income (instead of other forms) will keep the investor in a lower tax bracket.
Dividend payout policies
Several different payout policies exist for dividends. Constant payout is a very common choice of policy, where the stock company decide to pay a specific percentage of its earnings each year.
With a residual payout policy, the company retains a part of its earnings to finance the equity portion of its capital budget, before using residual earnings to pay dividends.
Stable payout is another option, where the company policy is to maintain a stable dividend payout year after year – even as the earnings vary. (Of course, a stable payout policy can require a revision if company earnings drop too low several years in a row.)
Special dividends are dividend payments made outside the fixed schedule for dividend payments. They tend to be one-time events. The stock company can for instance decide to sell off a specific subdivision of the company to a third-party buyer, and give the profits from that sale to the shareholders instead of retaining the money within the company.
If you enroll in the Dividend Reinvestment Program (DRIP), cash dividends will never reach you. Instead, the cash will automatically be used to purchase shares in the company for you.
This is a very convenient way of gradually increasing the amount of shares you hold in a company without having to use any other money than the dividend payments. The next time there are dividends to be paid, you own even more shares than before. Ceteris paribus, you will get an even bigger dividend payment, and this will be used to buy shares to increase your ownership even more, and so on, year after year.