What are Dividends? – Important Facts

Infographic that explains what dividends are.

A profit earned by any entity, be it an individual’s investments or a company return on investment, can be lucrative. Amongst the various increasing profitable investment options that have offered cumulative returns over time, stock dividends offered by companies and businesses have been one of the options.

What Is a Dividend? 

Companies that earn profit have two options to consider. One option is to reinvest the profit back into the business to reduce current debt, expand their business, or repurchase shares from the market. The second option is to share the profit amongst shareholders. This after-tax profit is shared per the number of stocks and the class of shares held by the shareholders. This is known as dividends.

Understanding Dividends 

Usually, the majority of the profit earned by a company is preserved as retained earnings. Retained earnings are funds that are allotted for the company’s current and future business activities. The remaining funds are then allocated to the shareholders as dividends.

In a traditional sense, dividends are considered a form of nominal recompense paid to shareholders who have invested in a company’s equity. This dividend normally originates from the company’s net profit. In certain cases, companies may also provide dividend payments even when the company earns no profits. This is normally undertaken to maintain an established record of regular dividend payments. Companies may also issue non-recurring dividends, in terms of individual or scheduled dividends, based on business performance and/or an improved financial outlook.

Before the dividends can be allocated, they must be approved by shareholders through voting rights. After that, they can be distributed as cash dividends, dividend stocks, or even property. Companies may also offer mutual funds or ETFs (Exchange Traded Funds) allocated dividends in certain cases. Shareholders can also vote on when dividends will be issued (monthly, quarterly, or annually) and the payout rates.

Dividend-Paying Companies

To get the best return on investment in dividend stocks or cash, it is best to invest in established companies with predictable profits. In addition to revenue growth, these companies often issue regular dividends to maximize shareholder wealth.

Companies in the following industries typically distribute dividends regularly:

  • Banks and financials
  • Basic materials
  • Healthcare and pharmaceuticals
  • Oil and gas
  • Utilities

Companies that are structured in the following ways also typically provide dividend payouts:

Companies in the following industries typically do not offer regular dividends:

  • Biotech companies
  • Early or mid-growth stage companies
  • Start-ups
  • Technology companies

The reason behind this is that these companies may be in the early stages of development. This may or may not incur high costs or losses due to R&D, business expansion, or even operational activities. Alternatively, companies aiming for higher than average growth and expansion may want to reinvest their profits back into their business instead of paying out dividends.

Important Dividend Date 

The payouts for dividends normally follow a chronological order of events. The associated dates are crucial for qualified shareholders in terms of receiving the dividend payments:

  • Announcement date: The date on which the dividends are announced by company management. This date must be approved by shareholders before the payout can occur.
  • Ex-dividend date: The date on which the dividend eligibility expires. This is also known as ex-date. Shareholders who purchase stocks on that date or the day after, as long it is a business day, will not be qualified to receive dividend payments on that particular purchase.
  • Payment Date: The date on which the dividend payment is issued. In other words, the date that the payout from the dividend is credited to an investor’s account.
  • Record Date: The date that is established by the company as the cut-off date. This date determines which shareholders are eligible to receive a dividend or distribution.

Impact of Dividends on Share Price 

As previously mentioned, dividends are issued based on the company’s profit or financial outlook. These dividends once paid out, cannot be rescinded, as they are permanently recorded in the company’s books and business accounts. As a result, any dividend payment can impact the share price. Changes in share price can occur in two ways:

  • Share prices rise on announcement of the approximate value of the dividend declared
  • Share prices decline at the opening session of the ex-dividend date.

Why Companies Pay Dividends 

The reasons why companies pay dividends can vary from company to company. However, here are some of the most common reasons:

  • Reward for investing: Shareholders expect dividends as a form of reward for trusting in the company they invest in. Management may honor this trust, by delivering a robust track record of dividend payments. Additionally, these payments also reflect positively on a company, by maintaining the investor’s trust. The benefits of paying dividends as a reward for investing include that these dividend payments are classified as tax free income especially under short-term gains. However, the disadvantage is, that when selling dividend shares, the resulting capital gain will be considered as taxable income.
  • Profit generation versus growth: Shareholders expect dividends based on the profit earning ability of the company. The Board of Directors has to make the decision whether to pay dividends or retain the profits and put the money back into the company for future growth. If the company decides to make a high value dividend declaration, it typically indicates that the company will continue to generate good profits. However, high dividend payments may result in the company having insufficient funds to generate higher returns in the future and this may affect the company’s growth rate.
  • Reflection of the company’s performance: Dividends are pay-outs based on the company’s profit-making performance. This performance impact’s the company’s share price, which in turn, affects the shareholder’s decision to invest in the company. Any change in dividend value may indicate a change in the profit-making performance of the company, and inadvertently, affect the stock price. What remains to be seen is whether this change in dividend value is due to management decisions focusing on reinvesting for a higher returns in the long run, or to compensate for the company’s declining performance.

A Note About Fund Dividends

Fund dividends versus company dividends

There is a considerable difference between dividend payments by funds and companies.

Dividend payouts by funds are usually distributed based on the principle of net asset value (NAV), which indicates the holding value or asset price that the fund may be tracking. Funds normally pay dividends sourced from their NAV. However, this may not indicate a stellar performance by the fund itself. Dividends from bond investing funds and stock investing funds can affect its holding value, which in turn, will be reflected in the NAV on the ex-dividend date.

Dividend payouts by companies are usually paid from profits generated by a company’s business operations.

Are Dividends Relevant or Irrelevant? 

Dividends can be relevant or irrelevant, based on the shareholder’s mindset. Proponents of dividend payouts and dividend investing argue that dividend income creates a steady stream of passive, investible income that can be used to purchase additional shares of the same stock or a different stock altogether. It is also a hedge against earnings volatility because a portion of the earnings is returned to the shareholders every year.

Detractors argue that the company should reinvest its income to grow the business and generate more earnings, resulting in a higher stock price. In either case, the combination of the value of an investment in the company and the cash they hold remains the same. Thus, shareholders can base their investment decisions centered on the company’s dividend policy. However, shareholders can also create their own version of a synthetic dividend policy. They can do this by divesting a portion of their stock portfolio annually and make the same investment decisions.  

In reality, dividends provide the opportunity to generate more funds. These funds can be used to

  • Reinvest in alternate financial securities for higher returns
  • Spend on leisure and other utilities
  • Provide funding for taxes, brokerages, and indivisible shares

Buying Dividend-Paying Investments

While deciding what types of assets you want to include in your portfolio is an important decision, another thing to consider is dividends. Should you include dividend-paying investments in your portfolio? To make this decision a little easier, you can use the dividend discount model or the Gorden growth model to help you anticipate future dividend streams and value shares.

Additionally, when comparing multiple stocks, the dividend yield factor can be used to calculate the dividend payment performance. This factor measures the dividend in terms of percent of the current market price of the company’s share. The dividend rate can also be classified in terms of dividends per share, the dollar amount each share receives. Furthermore, the total return factor must also be considered to measure performance in terms of returns generated from a particular investment. This accounts for interest, dividends, and an increase in share price among capital gain.

Another aspect to consider is tax. Investors who fall in the high tax brackets can invest in dividend-paying stocks only if the jurisdiction allows zero- or comparatively lower tax on dividends than the normal rates.

Understanding Dividend Growth Rate 

Savvy dividend investors look at three different metrics to evaluate the dividend quality of the stock: dividend yields, dividend payout ratio, and the dividend growth rate. The dividend growth rate is the annualized growth rate of dividend income in dollars over time. Corporations will typically increase their dividend growth rate when one or more of the following statements is true:

  • Their earnings are growing
  • Companies have reached a stage of maturity where they no longer need to invest a ton of capital

Beyond measuring the quality of a company’s dividend income and dividend policy, the dividend growth rate is also a key input in the dividend discount model, a valuation model used to determine the intrinsic value of stocks.

A Word on Frequency of Dividend Payments

The frequency with which a company pays dividends is entirely at the discretion of its board of directors. Some companies may choose to make quarterly dividend payments, while others may choose to make annual dividend payments. A company may also choose to offer special dividends on a one-time basis, usually the result of a windfall, a surplus of cash on hand, or some other variant.  

Conclusion

Dividend stocks are often known as retiree investments that provide a regular stream of income. However, dividend stocks are much more and can play a role in any portfolio, regardless of the investor’s age.

Remember, dividends can be reinvested. When you reinvest your dividends to buy more shares, not only do you own more shares, but your future dividend payments will most likely go up as well. This is the power of compounding at work and makes dividend stocks a good investment option for many investors.

However, like any stock, dividend stocks are subject to various risks, such as company-specific risks and market risks. Also, keep in mind that dividends are not guaranteed. A company can decide at any time to reduce its dividend payments or even stop them completely.

Depending on your risk tolerance, investment horizon, and income needs, dividend stocks might be a good addition to your portfolio.

Additional Reading:

Determinants of Dividend Policy: A Study About the Impact of Changing Firm Characteristics on Dividend Payout Ratios, by Hira Ahmad, May 31, 2019

Vikram R
Vikram Raghavan is a value investor, technologist, and Finexy co-founder. In addition to stock market investing, Vik also invests and advises startups on growth marketing and product management. Vik's work is focused on themes of marketplaces, micro-entrepreneurship, marketing automation, and user growth. Previously, Vikram led product and growth teams at Overstock.com, focusing on efforts across acquisition, new user experience, churn, and notifications/email. He holds an MBA in Finance from Temple University and a B.S. in Computer Information Systems and Finance from Bemidji State University.