How Do Dividends on Stocks Work?

The ultimate value of a stock for an investor is comprised of two components including the appreciation in value and the return of dividends. In fact, the formula for return on investment in a stock is the new price minus the initial price plus the dividends all divided by the initial price of the stock. However, the payment of dividends to investors depends on a formal process.

Dividend Rules

Dividends are cash or stock, usually paid on a quarterly basis to all investors who hold the stock. Investors receive the funds on a per share basis. The dividends must be approved by the board of directors and publicized to all shareholders at the same time. In addition, the company must inform the exchange that they will be issuing dividends, when they will be distributed and what type of issuance they will be.

Dividend Reinvestment

Most large brokerage houses will provide you two options for your dividends. First, you may take them in cash and add it to your cash on hand in the account. You can also automatically reinvest your dividends in the shares of the company that issued them. In this case, the brokerage will use the dividend to buy partial shares of the stock for you. The brokerage itself will hold the whole shares and divide the value among the clients holding those stocks.

Dividend Funds

Investment funds that take in dividends must- distribute some of those dividends to investors in the fund. In fact, some mutual fund companies specialize in investing in companies with high dividend yields so that they can provide regular cash distributions to investors. Real Estate Investment Trusts -- REITS -- that invest only in real estate are required to return over 90 percent of their income to investors in the form of dividends. Successful companies attempt to increase their dividends annually, providing a very attractive return on investment for these funds.

Qualified Dividends

The Jobs and Growth Tax Relief Reconciliation Act of 2003 created the concept of qualified dividends. Investors who hold stocks for greater than 61 days can treat the cash as qualified dividends for tax purposes. These are taxed at the much lower capital gains rate rather than the regular income tax rate. Qualified dividends are reported on Form 1099 to the IRS.