Written by Brenda Nakalema

An introduction to Dividends.

Dividends refer to the distribution of some company’s earnings to a class of its shareholders, which is determined by the …

Dividends refer to the distribution of some company’s earnings to a class of its shareholders, which is determined by the company’s board of directors. Holders of a company’s common stock (dividend-paying companies) are usually eligible to receive dividends as long as they hold the stock before the actual ex-dividend date.

In most cases, before dividends can be awarded, the shareholders must approve them through their voting rights. Although cash dividends are the most common amongst most companies, dividends can also be issued as shares of stock or other property. Mutual funds and exchange-traded funds (ETFs) typically pay dividends as well.

A dividend is essentially a small reward paid to shareholders for their investment in the company’s equity, and it is usually paid after a company reports substantial net profits. Despite the bigger portion of a company’s profits being held back as retained earnings, a small portion could be paid out to shareholders. In rare cases, companies might still opt to pay out dividends even when they don’t make substantial profits. They may do this to preserve their reputation as companies that pay regular dividends.

A company’s board of directors can choose to issue dividends over different periods of time with different pay-out rates. Dividends can be paid at scheduled intervals: monthly, quarterly, or even annually.

Companies can also choose to issue non-recurring special dividends, either to specific individuals or in addition to scheduled dividends.

How Dividends Work

A dividend is valued based on a per-share basis and is paid equally to all shareholders of the same class of shares (common share, preferred shares and others). Before the payment is made, it must first be approved by the Board of Directors. Once a dividend is declared, it will typically be paid on a certain date, also known as the payable date.

Step 1: First, the company generates profits and retained earnings.

Step 2: The management team makes the decision about whether or not dividends should be paid based on the excess profits made by the company. The management must choose between reinvesting profits or paying them out as a dividend.

Step 3: The management secures board approval before paying out the dividend.

Step 4: The company announces the dividend (the value per share, the date on which it will be paid, the record date and other important information).

Step 5: The dividend is paid to shareholders.

Types of Dividends

There are different types of Dividends a company may opt to pay out to shareholders.

  • Cash: In this case, the dividend is paid in hard cash using different channels from the company directly to shareholders and is the most common type of payment. The payment is typically sent electronically but might also be paid by check or cash.
  • Stock: With this option, dividends are paid in the form of additional stock by issuing new shares to the company shareholders. These are paid out on a pro-rata basis, depending on the number of shares the investor already owns.
  • Assets: A company may also pay its dividend in the form of other assets such as investment securities, physical assets, and real estate. This is not a common form of dividend payment.
  • Special: A special dividend is a type that’s paid outside of a company’s regular dividend policy (i.e. quarterly, annual, etc.). This is typically the result of having excess cash from company operations on hand for whatever reason.
  • Common: This is paid specifically to a certain class of shareholders, i.e. those who own the company’s common shares.
  • Preferred: This is paid specifically to shareholders who own preferred stock in the company.
  • Other: Companies might also choose other forms of payment to pay out to shareholders as dividends, such as options, warrants, shares in a spin-out company etc.

Dividend Vs Buyback

There are different distributions managers of big companies can make to shareholders. The two most common are dividends and share buybacks. A share buyback is used by a company to repurchase shares in the open market using cash on its balance sheet. This move can have two notable effects;

  • It returns cash to shareholders
  • It reduces the number of shares outstanding.

Usually, a company would perform share buybacks as an alternative means of returning capital to shareholders to help boost a company’s EPS. By opting to reduce the number of shares outstanding, the denominator in EPS (net earnings/ shares outstanding) is reduced, increasing the EPS. Because managers’ performance is judged on their ability to grow EPS, they are often advised to follow this strategy.

Dividend-Paying Companies

The best dividend payers are typically large companies with established track records and predictable performance over a long time period. These companies tend to issue regular dividends; they seek to maximize shareholder wealth in different ways aside from regular growth. The following sectors are comprised of large companies that typically pay regular dividends;

  • Basic material
  • Oil and Gas
  • Banks and Financial
  • Healthcare and pharmaceuticals
  • Utilities

Dividend pay-outs are common among companies structured as master limited partnerships (MLPs) and real-estate investment trusts (REITs) mostly because their designations require specified distributions to shareholders. Funds might also choose to issue regular dividend payments as stated in their investment objectives.

Companies in their early growth stages and those in the very volatile environments might opt not to issue dividends, for example, start-ups and other high-growth companies. This is mostly because these companies typically incur high costs and losses due to different things like research and development, business expansion, operational activities and other high costs leaving them with little to spend on dividend pay-outs.

This is true even for profit-making early- to mid-stage companies that might seek to avoid making dividend payments if their ultimate goal is to make higher-than-average growth and expansion and would therefore rather reinvest their profits into the business operations.

Important Dividend Dates

Dividend payments follow a specific chronological order of events; therefore, shareholders can determine whether they qualify to receive a dividend based on the date a pay-out corresponds to.

  • Announcement date: Company management announced the date on which dividends will be paid out but must be approved by shareholders before the actual pay-out is made.
  • Ex-dividend date: This is referred to as the date on which the dividend eligibility expires. For example, a stock could have an ex-date of Tuesday, Feb 2, which would mean that shareholders who buy the stock on or after that date would not be eligible to get the dividend.
  • Record date: This refers to the cutoff date determined by the company in order to establish which shareholders are eligible to be paid a dividend or distribution.
  • Payment date: On this date, the company’s payment for the dividend is issued, which is when the money gets credited to investors’ accounts.

Impact of Dividend on Share Price

Dividend payments cannot be reversed and therefore result in a large outflow of money from the company accounts. Therefore dividends typically impact share price, which may arise on the announcement roughly by the amount of the dividend declared and then eventually decline by a similar amount at the opening session of the ex-dividend date.

For instance, a company trading at $50 per share declares a $2 dividend on the announcement date. Once the news goes public, the share price shoots up by roughly $2 and hits $52. In case the stock trades at $53 on the business day prior to the ex-dividend date. On the ex-dividend date, it’s adjusted to $2 and ends up trading at $51 at the start of the trading session on the ex-dividend date because anyone buying on that date will not receive the dividend.

Although this isn’t written in stone, the stock price is usually affected when dividend pay-outs are announced.

Why Companies Pay Dividends

There are a number of reasons a company would choose to pay dividends; here are a few of them.

  • Dividends are seen as a reward for the shareholder’s trust in the company. The company management might consider it essential to maintain this trust by paying out a regular dividend. Shareholders highly favour dividends because they are a tax-free income in many countries.
  • A dividend pay-out might also be a company’s way of steering positive PR. A high-value dividend declaration can be an indication that a company is doing well. Conversely, it could also be a cause for concern- an indication that the company doesn’t have suitable projects to invest in and generate better returns for the future.
  • In instances where a company has a long history of regular dividend pay-outs, failure to pay might cause panic or speculation among investors about the health of the company, which might, in turn, affect its share price.

This can be countered by the fact that a reduction in dividend pay-out isn’t necessarily a bad thing. It could indicate the company’s focus on the future by its decisions to invest in a high-return project that might have the potential to magnify returns for shareholders in the long run, as compared to the small gains they would receive if a dividend was paid out.

Fund Dividends

There’s a notable distinction to be made between dividends paid by funds and those paid by companies. Company dividends are typically paid from profits that the company’s business has generated; on the other hand, funds operate according to the principle of net asset value (NAV), which is a reflection of the valuation of their holdings or the price of the assets that a fund might be tracking. Since funds don’t actually have intrinsic profits, their dividend pay-outs are sourced from their NAV.

As a result of the NAV method of calculating dividends, a regular and high-frequency dividend pay-out by a fund shouldn’t be mistaken for a great performance by the fund. For example, a bond-investing fund might pay monthly dividends as it receives money in the form of monthly interest on its interest-bearing holdings. The fund is simply transferring income from the interest fully or partially to investors.

A stock fund might also choose to pay dividends. Its dividends could come from the dividends it receives from the stocks it holds in its portfolio or by putting a certain quantity of stocks on sale. It’s likely that investors receiving the dividend from the fund would be reducing their holding value, which is reflected in the reduced NAV on the ex-dividend rate.

Important to facts to note about Dividends

Taxes: One of the important factors to consider is the fact that dividend income is taxed at ordinary income rates, provided the shares are held in taxable brokerage accounts. An investor might consider owning shares through a tax-advantaged account like a traditional or Roth IRA to prevent this.

Dividends can be cut-down: A company can choose to reduce its dividend pay-out or even completely eliminate it, especially in cases of financial difficulty. Investors should therefore be especially selective when choosing company shares to buy; in certain instances, even very high-yield stocks can turn out to be too good to be true. The way to mitigate the risk is by owning a diversified group of companies through an index fund.

Rising interest rates: Rising interest rates could pose a threat to funds and ETFs with high dividend yields because as rates climb higher, investors who initially purchased dividend funds to boost their income opt for high-yield stocks and turn towards safer assets such as bonds, causing prices to drop.

How relevant are dividends?

According to Merton Miller and Franco Modigliani, a company’s dividend policy isn’t relevant and has no effect on the share price of a firm’s stock or its cost of capital. Theoretically, a shareholder might remain undeterred by a company’s dividend policy. Incase of high dividend payments, they can utilize the cash received to purchase more shares. Although reinvesting dividends would be the smart choice, it’s not always the best option on the table.

Economists Miller and Modigliani conclude that dividends aren’t important and that investors shouldn’t care about a company’s dividend policy because they can technically create their own synthetically. For example, in the instance of low payments, they can opt to sell some shares to get the cash they need. Whatever the case, the combination of the value of an investment in the company and the cash they hold will ultimately remain the same.

Despite these sentiments, in reality, dividends allow money to be made available to shareholders, which gives them the liberty to get more utility out of it. They can choose to invest in other financial securities and reap even higher returns or spend their pay-outs on leisure and luxury. Also, costs like taxes, brokerages and invisible shares increase the appeal that dividends have.

Another advantage of dividends is that they can be used to offset brokerage and tax costs.

Buying Dividends- Paying Investments

Investors seeking dividend investments can have their pick when it comes to where they get to put their money, including stocks, mutual funds, exchange-traded funds, and more. The dividend discount model and the Gordon growth model are both great ways to decide which stocks to choose. These techniques use anticipated future dividend streams to value shares.

In order to compare multiple stocks based on their dividend payment performance, investors can utilize the dividend yield factor, which measures the dividend in terms of a percentage of the current market price of the company’s share. Another way to quote the dividend rate is in terms of the dollar amount each share receives- dividends per share (DPS). Aside from the dividend yield, another crucial factor to consider when measuring the performance is to assess the returns generated from a particular investment in the total return factor. This figure accounts for interest, dividends, and increases in share price, among other capital gains.

An investor must also be aware of the tax implications when considering dividends. Investors in high tax brackets usually prefer dividend-paying stocks if the jurisdiction allows zero or comparatively lower tax on dividends than the usual rates.

How are Dividend Stocks Taxed?

Dividends are usually taxed at the same rate as regular income, while the rate of taxation on capital gains depends on how long an investor has held the asset and their income level. The taxation applied to dividends will depend on the type of account an investor holds in them in. If an investor holds the stocks or dividend-paying funds in an individual or joint account, they will pay taxes on the dividends received as well on any realized gains earned.

If an investor holds dividend stocks or funds in tax-advantaged accounts like traditional or Roth IRA, they won’t be taxed on the dividends or their realized gains.

In conclusion, Dividend can have a great impact on an investor’s portfolio over time and are definitely a great way to earn a good income during retirement, or earlier. They are seen as a long-term investment strategy with the aim to earn a regular, fairly predictable and often-times tax free income.