Understanding Dividends
What are they & how they work
A dividend is a portion of the profits that a company pays to its shareholders.
Companies that earn a profit can do one of three things:
pay that profit out to shareholders, reinvest it in the business through expansion, debt reduction or share repurchases, or both.
When a portion of the profit is paid out to shareholders, the payment is known as a dividend.
Usually, companies that are on a high-growth trajectory and would require a good amount of capital to fund that growth won’t pay many dividends.
Instead, they invest the profits to fund its expansion and business growth.
On the other-hand companies that have already achieved high growth and are market leaders with solid cash flow may share the profits with shareholders in the form of dividends.
Long time back investors used to make stock investments primarily to earn dividends.
However, today’s investor looks for both dividends and capital gains as a means to increase his wealth.
The Process Dividends must be declared (i.e., approved) by a company’s Board of Directors each time they are paid.
There are three important dates to remember regarding dividends.
(i) Declaration date
The declaration date is the day the Board of directors announces their intention to pay a dividend.
On this day, the company creates a liability on its books; it now owes the money to the stockholders. On the declaration date, the Board will also announce a date of record and payment date.
(ii) Date of record
This date is also known as “ex-dividend” date.
It is the day upon which the stockholders of record are entitled to the upcoming dividend payment.
According to Barron’s, a stock will usually begin trading ex-dividend or ex-rights the fourth business day before the payment date.
In other words, only the owners of the shares on or before that date will receive the dividend.
If you purchased shares of Hero-Honda after the ex-dividend date, you would not receive its upcoming dividend payment; the investor from whom you purchased your shares would.
(iii) Payment date
This is the date the dividend will actually be given to the shareholders of the company.
Types of Dividends
(i) Cash Dividends
Regular cash dividends are those paid out of a company’s profits to the owners of the business (i.e., the shareholders).
A company that has preferred stock issued must make the dividend payment on those shares before a single penny can be paid out to the common stockholders.
The preferred stock dividend is usually set whereas the common stock dividend is determined at the sole discretion of the Board of Directors (for reasons discussed later, most companies are hesitant to increase or decrease the dividend on their common stock).
(ii) Property Dividends
A property dividend is when a company distributes property to shareholders instead of cash or stock.
Property dividends can literally take the form of railroad cars, cocoa beans, pencils, gold, silver, salad dressing or any other item with tangible value.
Property dividends are recorded at market value on the declaration date.
(iii) Time Dividends
In addition to regular dividends, there are times a company may pay a special one-time dividend.
These are rare and can occur for a variety of reasons such as a major litigation win, the sale of a business or liquidation of an investment.
They can take the form of cash, stock or property dividends.
Due to the temporarily lower rates of taxation on dividends, there has been an increase in special dividends paid in recent years.
To add sugar to spice, there are times when these, special one-time dividends are classified as a “return of capital”.
In essence, these payments are not a payout of the company’s profits but instead, a return of money shareholders have invested in the business.
As a result, the return of capital dividends is tax-free.
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