To The Moon

Dividends are paid out to shareholders if company profits exceed certain thresholds. How does the stock market work? What happens to the value of a stock over time? A fundamental understanding of how corporations make money is necessary to gain a full picture of the stock market. Let's take a look at some basic terminology related to stocks before we dive deep into how they actually work.

The Basics of Dividend Stocks

A dividend is an amount of cash or shares that companies pay investors out of their quarterly earnings (also known as net income). Investors who own stocks have the right to receive these payments in addition to any other forms of compensation they may be receiving. Companies are not obligated to pay out dividends, however in many cases they choose to do so in order to reward their shareholders. In fact, the majority of U.S.-based companies now pay dividends.

Corporations are legally allowed to distribute earnings instead of paying them out as cash. If corporate shareholders agree that the company should issue dividends, then those earnings are distributed out in the form of cash or additional shares. This gives shareholders access to potential future profit that could be generated by the corporation and provides them with a share ownership stake in the business.

Companies use dividend distributions for several reasons. Sometimes companies simply need to raise capital, while others might want to give back to investors. There are also many ways in which a company can manipulate its payout in order to benefit themselves. However, in general, companies do want to pay out dividends.

What Happens When Stock Prices Go Up?

When a company starts earning higher profits, their stock price begins to rise. As long as the company continues to earn profits, the stock price will continue to increase. Once the company exceeds a specific threshold, called a trigger point, they begin issuing dividends.

The difference between earnings and sales is what determines whether or not a company will meet their dividend payout requirements. Sales are the total amount of revenue the company generates. Earnings are calculated separately and includes profits plus interest, taxes, depreciation, and amortization costs. These amounts are added together and divided by the number of outstanding shares to determine EPS (earnings per share).

Earnings are used to calculate the dividend payment. EPS is subtracted from the current stock price to arrive at the per-share dividend. Companies often use a formula based on the ratio of EPS to the previous year's EPS. This ensures that dividend payments remain consistent even if profits fluctuate.

Why Are Stocks Important?

Stocks allow investors to participate in the success of businesses. By purchasing individual shares of companies, investors become stakeholders in the outcome of the business. Shares represent an investor's claim on the assets of the business; as the value of the company increases, so does the value of each share. Shareholders are able to sell their shares (or portions of them) whenever they wish, meaning that they're no longer tied down to the fortunes of a particular company.

However, this freedom comes with risk. By selling off shares at a lower price, an investor can lose the value of his investment. On the flip side, as a shareholder, an investor receives regular dividends as well as the opportunity to vote on major decisions like mergers and acquisitions.