A dividend is a fraction of company earnings returned to shareholders. It works like a monetary bonus or interest payment. Both private and public companies pay dividends. And the Board of Directors decides whether or not a dividend will be paid.
When a company earns a profit and enjoys surplus cash, it can opt to pay a fraction of this to its shareholders in the form of a dividend.
Therefore, a dividend is a transfer of assets. This is most usually cash, made by the company, directly to its existing shareholders.
Dividends are usually declared annually and paid out periodically. This is at the sole discretion of the company’s dividend policy and may be paid annually, half-yearly or quarterly.
When a dividend is declared, its payment date is set, along with an ex-dividend date. Only registered shareholders on the date before the stock goes ex-dividend are eligible for the dividend payment.
How a dividend works
As a company accumulates profit, it needs to decide whether to reinvest that profit in growing the business. Sometimes it does not need to keep reinvesting as the business is ticking along nicely as it is. Therefore, it decides to pay a dividend to reward investors for their loyalty and maintain the company’s value.
Dividends help snowball wealth, which keeps investors coming back for more. Meanwhile, investors buying shares in the company help elevate its market cap.
The value of a dividend is determined per share in the company. That’s so it can be equally distributed dependent on an investor’s holding.
A dividend is paid equally to all shareholders of the same class. Shareholder classes are split into common stock, preferred stock, or bespoke classes (See: What is a stock?)
The Board of Directors must agree and approve the dividend payment, and the date to be paid is set.
Why do companies pay dividends?
It is common practice for companies to pay dividends to investors when they have excess cash left after expenses. However, it is more common for well-established companies to pay dividends than small, growth-stage companies.
That’s because, during the growth stage, reinvesting any spare cash in the company’s development is deemed a more worthy cause than rewarding loyal shareholders.
But once a company has achieved considerable growth, sharing the profits with shareholders is an excellent way to entice and reward loyalty.
Some cyclical industries such as oil and gas experience extreme share price volatility. By paying a healthy dividend, the company can counteract this volatility and attract investors to the stock. This often stabilizes or raises the share price.
Shareholders like dividends because, over time, they can compound their capital base and accumulate significant returns.
Types of dividend
There are various types of dividends:
- Cash dividend
- Stock/Scrip dividend
- Property dividend
- Liquidating dividend
- Special dividend
The Cash Dividend is the most common form of a dividend. In this case, the company declares a cash dividend to shareholders and, on the payment date, deposits the cash in their designated bank or investment account.
The cash received is directly relative to the number of shares held by the investor. Sometimes the broker will give the shareholder the option to take a cash dividend in cash or have the money reinvested as shares.
Occasionally a company will issue additional shares to common stockholders. This is called a Stock Dividend and is also known as a Scrip Dividend.
A stock dividend allows the company to reward shareholders without reducing its cash balance, but it does run the risk of diluting earnings per share. A stock dividend is similar to a stock split in that it dilutes the share price but does not affect the company’s value.
If the stock dividend declared, amounts to less than 25% of total shares outstanding, then it is classed as a small stock dividend. In accounting terms, the small stock dividend transfers the market value of the issued shares from retained earnings to paid-in capital.
However, if the stock dividend declared is more than 25%, it is classed as a large stock dividend. In accounting terms, the large stock dividend transfers the nominal value of the issued shares from retained earnings to paid-in capital.
The shareholder is not taxed on their stock dividends until they choose to sell them and sometimes the Board opts for a Stock Dividend over a Cash Dividend simply to preserve the company capital.
Although uncommon, a company has the option to issue non-monetary dividends to its shareholders. This can include physical assets such as property. At the time of issue, the asset value would be recorded against its current market price.
This type of dividend can be manipulated because asset prices fluctuate. Therefore, the property’s value could be marked in the accounts at a profit or loss depending on whether it is above or below book value.
There’s a risk a business may issue a property dividend to manipulate their taxable income.
If the company is wholly or partially closing, the board may opt to return the original capital invested to its shareholders. This is called the Liquidating Dividend.
It is made from the company’s capital reserves and is non-taxable because it returns original capital to shareholders.
A company Board may sometimes pay out a Special Dividend. This is like a bonus payment when the company has had an outstanding period or a windfall.
This may be due to selling a division or company assets, enjoying a particularly profitable quarter, or it may be in keeping with altering its financial structure.
A Special Dividend payment is usually a one-off, paid in cash, and bigger than regular dividend payments.
Advantages of a dividend
From an investor’s point of view, one of the best things about dividends is the power of compounding. This is because it increases the capital base, which attracts further gains and can exponentially grow the pot.
What happens is, when the holder of shares reinvests the dividends received, their wealth accumulates.
The more dividends reinvested, the more shares the holder owns, and the more shares owned, the larger future dividend payments become.
When an investor builds a portfolio full of dividend stocks, the power of compounding quickly becomes apparent and is often used as a tactic to create a retirement income.
For instance, $5,000 invested at the outset, which attracts a 5% dividend year annually for 40 years, would result in a final sum of $35,199.94.
If the investor added $100 a month during this time, the final sum would be $183,452.40. Effectively gaining interest worth $130,452.40.
From a company’s point of view, a dividend is a valuable tool for enticing investors. That’s because doling out dividends increases investor faith in the business.
Disadvantages of a dividend
Investors do not always welcome dividends. Sometimes they can be used manipulatively to keep shareholders loyal when the funds would be better spent on enhancing and growing the business.
Sometimes a stock or scrip dividend may signal cash shortages or distress within the company. In riskier industries such as mining and oil, a dividend can cast doubts on management if the company is involved in particularly risky projects.
In a downturn or unexpected financial shock, such as that created by the financial crash of 2008 and the Covid-19 pandemic in 2020, dividend payments can be cut or canceled.
In 2008, 40 S&P 500 companies cut their dividends, and 22 announced suspensions. And, between February 2020 and the end of June 2021, a whopping 526 companies cut their dividends.
What is a dividend yield?
A dividend yield is a percentage representation of the size of the dividend being paid out. Accordingly, the dividend yield is a financial ratio of dividend/price. The dividend yield is calculated by dividing the dividend per share by the stock price per share.
For instance, Exxon Mobil’s latest fiscal dividend per share is $3.48. Its current stock price is $60.41.
Therefore, 3.48/60.41 x 100 = 5.76, so Exxon Mobil currently offers a dividend yield of 5.76%.
What is a dividend yield ratio?
The dividend yield ratio is a financial ratio relating the cash return from a share to its current market value.
What is a dividend cover ratio?
The dividend cover ratio is a financial ratio relating the earnings available for dividends to the dividend announced. This indicates how many times the company earnings cover the dividend payment.
Essentially, the dividend cover ratio measures the number of times a company can pay its current level of dividends to its shareholders.
It’s commonly thought a dividend cover ratio of more than 2 is reasonable. Anything below 1.5 may mean the dividend is at risk of being cut or canceled.
The general formula for calculating the dividend coverage ratio is:
Dividend Coverage Ratio = Net income / Dividend declared
What is the dividend payout ratio?
The dividend payout ratio is the financial ratio relating the dividends announced for the period to the earnings generated during that period.
This equates to how they are calculated relative to the company’s net income during that time.
Some of the top dividend-paying US stocks in 2021:
AT&T (NYSE: T) is a telecommunications company paying a dividend yield exceeding 7%.
Gaming and Leisure Properties Inc (NASDAQ: GLPI) is a real estate investment trust company (REIT) paying a dividend yield of 5.8%.
Exxon Mobil Corporation (NYSE: XOM) is an American multinational oil and gas company paying a dividend yield of 5.7%
IBM (NYSE: IBM) is a computer hardware company with a dividend yield of 4.6%.
Where’s the Value?
- Strong and secure: in terms of large-cap companies, a dividend payment usually signifies strength and confidence in a company.
- At the company’s discretion: remember that the payment of dividends is solely at the discretion of the individual company.
- Variety is the spice of life: although cash dividends are the most common type, there are various others available, so make sure you do your research on what a company offers.