Click here for the Club Mailbag email address (investingclubmailbag@cnbc.com). Please direct your questions to Jim Cramer and his team of analysts. We cannot provide personal investment advice. We only consider more general questions about the investment process and stocks in your portfolio and related industries. This week’s question: Hi Jim, could you please do a segment where we explain more about dividends?I’ve been investing for many years and listen to many investment podcasts, including “Mad Money,” but I always feel like the pros and cons aren’t explained properly or are misleading. Specifically, I think most investors (and many advisors) believe that dividends are a free lunch. But my understanding is that they do not generate net income, only tax outflow. — Standard There are two main ways companies return cash to shareholders: dividends and stock buybacks. Both are good events and have relative advantages and disadvantages. Stock buybacks occur when a public company buys and cancels its own stock in the open market, thereby reducing the number of shares outstanding. Since the number of shares is the denominator in the calculation of earnings per share (net income divided by the number of shares outstanding), reducing shares increases EPS for remaining shareholders. This is also seen as a vote of confidence by the company, and often causes the stock price to rise. Dividends, on the other hand, occur when a company pays out a portion of its profits to shareholders. This is usually done on a per share basis. In other words, the more shares you own, the bigger your payout will be. Dividends are typically paid quarterly, but some companies may pay them monthly, semi-annually, or annually. Important Dates for Dividends When it comes to dividends, there are three (actually four) important dates to be aware of. The declaration date is the date on which the company announces the dividend and the amount to be paid. The ex-dividend date is the deadline for receiving dividends. Investors must own the stock before this date to receive the dividend. You will receive the record date (day 4 above) 1-2 days after the ex-dividend date. There’s nothing of note here for investors, just a note of who the company needs to get paid. The payment date on which dividends are deposited into your account. The ex-dividend date is an important date for investors to note, as dividends must arrive before this date to receive them. On the day a stock goes ex-dividend, the dividend is “sucked” out of the stock price. Therefore, if a $100 stock pays a quarterly dividend of $1, you would expect the stock price to fall to $99 per share on the ex-dividend date. So you still have $100 of value left, and you just have $99 in stock and $1 in USD (or additional shares if you want to reinvest). That being said, price corrections always occur when the market is open, so they are often masked by day-to-day price movements resulting from general stock buying and selling. So, which is preferable, stock buybacks or dividends?It depends. Dividends are usually best for people who rely on cash flow from their stock portfolios, such as retirees. Management is reluctant to cut or eliminate dividends. This is because dividends can send a very bad signal to investors about a company’s health, and dividends provide a reliable source of income to cover regular expenses. However, dividends are taxable even if they are reinvested. Taxes vary depending on the investor’s own financial situation and the type of dividend. Qualified dividends that have holding requirements and meet other IRS rules are taxed at lower long-term capital gains tax rates (0% to 20% depending on income bracket). Ordinary dividends are subject to higher ordinary income tax rates. The main reason some investors, especially those who don’t need the cash flow from dividends, prefer stock buybacks is the tax implications. Stock buybacks are taxed at just 1%, which is paid by the company. Therefore, from a shareholder’s perspective, the tax impact of share buyback activities is not felt. While the EPS impact of share buybacks is direct, the benefit to shareholders is more indirect as it relies on the willingness of multiple profit-oriented investors. For example, if you have a $100,000 position in XYZ stock with a 2% yield, you will receive $2,000 in dividend income per year. As long as the underlying fundamentals remain intact, you can rely on a payout to be made even if the stock is sold by 20% for reasons unrelated to the long-term financial health of the company, such as geopolitical events or broader market corrections. On the other hand, if you have a $100,000 position in ABC stock and no dividends are paid, you might be able to sell 2% of your stock to raise the $2,000 you need for income. However, if the shares are sold, more shares will need to be sold to raise the required funds. Conclusion Dividends are a good option if you need income from your portfolio to cover your expenses. However, dividends that are only reinvested are taxed. (Tax-advantaged accounts are also an option, but investors will ultimately have to pay taxes on dividend stocks.) Stock buybacks may be preferable because they can grow earnings over the long term without imposing taxes on shareholders. For this reason, it’s best to hold dividend stocks in a tax-advantaged account if possible so that compounding can occur tax-free. (See here for a complete list of INJim Cramer’s Charitable Trust stocks.) As a subscriber to Jim Cramer’s CNBC Investing Club, you will receive trade alerts from Jim Cramer before he makes a trade. After Jim sends a trade alert, he waits 45 minutes before buying or selling stocks in his charitable trust’s portfolio. If Jim talks about a stock on CNBC TV, he will issue a trade alert and then wait 72 hours before executing the trade. The above investment club information is subject to our Terms of Use and Privacy Policy, along with our disclaimer. No fiduciary duties or obligations exist or arise from your receipt of information provided in connection with the Investment Club. No specific results or benefits are guaranteed.
