You can make money investing in stock in two ways: capital appreciation and dividend income. Capital appreciation occurs when the market price of your stock rises above the price you paid to acquire it. Dividend income represents a return to the shareholders of a portion of the profits earned by the company. The amount of dividends paid out by the company can affect the price of the underlying stock.
Companies are in business to make a profit, although there is no guarantee that they will do so. If a company does make a profit, it can retain the earnings and use that money to fund growth, pay operating expenses, invest or save for future expenses; or it can pay the earnings out to shareholders in the form of dividends. The company's board of directors determines whether to retain the earnings, pay dividends or a combination of the two.
Dividends are paid equally to all outstanding shares of stock. Dividends are typically paid in cash, although they may be paid in additional shares of company stock. Some companies allow shareholders to reinvest dividends and purchase more shares of stock.
Dividend payouts are made to the stockholder of record as of the ex-dividend date. Stockholders who purchase shares of the stock after the ex-dividend date are not entitled to the dividend. Prior to payment of the dividend, the earnings are part of the company's assets, which increases the value of each individual share of stock by the amount of the dividend. Once the dividend is paid, the amount is deducted from the value of each share and the share price is adjusted accordingly.
Mature companies with a proven track record of success and profitability are more likely to pay dividends than companies in the growth stage, which are more apt to need to cash to fuel further growth and expansion. Companies with a long history of paying regular dividends in both good and bad economic times are called “blue chip” stocks. The market price of blue chip stocks tends to be less volatile than for growth stocks. Companies in the growth phase that reinvest retained earnings rather than paying dividends may have greater potential for capital appreciation than blue chip stocks.
- Thinkstock/Comstock/Getty Images