A dividend is the distribution of share of after-tax net profits and earnings of a company to a class of its shareholders. When a company generates net profit and accumulates corporate earnings, those earnings are either reinvested by the company itself for its expansion, kept as reserve or paid out to shareholders as a dividend. Dividend yield is the annual dividend per share divided by the price of the share. Dividends can be paid off in two forms – cash or stock.
It is the board of directors of the particular organization who decide the actual dividend payout rates over various time frames that the firm will pay out, though approval of shareholders is also required. Frequency of dividends could be monthly, quarterly or annually. Small upcoming companies may distribute dividends at the end of financial year while larger publicly held companies may distribute it quarterly. It is not mandatory for any company to pay out dividends in case the firm needs cash for reinvestment or may fall short of cash and cannot liquidate cash, it may skip paying dividends.
Types of dividends
- Cash: It is the most common type in which retained profits are distributed to shareholders in the form of cash.
- Stock dividend/bonus shares: The company can issue additional shares to the shareholders in proportion to the shares already held by them. This is usually done when a firm in not in a condition to pay in cash.
- Scrip dividend: The company issues a promissory note to the shareholders to pay back the dividend amount at a future date. Again, these dividends are issued in cases where company cannot afford to pay in cash.
- Asset dividend: Not only cash or shares, a company can also pay out in the form of assets like real estate, investment securities.
Dates linked to dividends
- Announcement date: the date on which the dividends are announced by company management.
- Ex-dividend date: Dividend eligibility expires on this date because anyone who buys the stock after ex-date are not eligible to receive dividend.
- Record date: It is the cut-off date used to determine the eligibility of shareholders to receive dividends.
- Payment date: It is the date on which dividends are issued by the company.
Dividends and stock prices
As soon as the company declares its quarterly results and dividend payouts, it has direct and great impact on the pricing of the outstanding shares trading in the market as well as number of shares that are going to trade in. For example, Company A has its shares trading at $50 per share and $3 is dividend declared on announcement date. As soon as the results are declared and become public, the share price is going to shoot up by $3 and fix at $53. If the share was trading at $54 one day prior to the ex-date, it will come down again by $3 and would be trading at $51 on the ex-date trading session because anyone who buys stocks on ex-date are not eligible to receive dividend.
Correlating Dividend and financial status of a company
Dividend distribution may be considered an indicator of positive financial future and strong performance of the company. If a company has declared desired dividend payouts, it retains the trust of the investors. But if a company decides against dividend payout or there is a reduction in the dividend amount, it does not necessarily indicate that the company is not performing well or has not generated any profits. It may be the case that company’s board of directors decide to reinvest the money for future growth and larger profits in the future or may decide on to buy back shares, which may increase returns for shareholders in a long run as opposed to petty short term gains through dividend payments.
Mutual fund investments provide two options for its investors – growth or dividends. In case of growth option, the profit returns are being reinvested leading to rise in NAV of the scheme overtime. In dividend option, profits are not reinvested, but distributed to the investor from time to time. Investors are only paid dividends when mutual fund schemes make profits from the scheme and it reduces their holding value and it is paid from the NAV of the unit. It is just a withdrawal from the investments, which comes at the cost of NAV.
Why choose a dividend paying investment?
- Investors looking for regular income can opt dividend option, though one should keep in mind that dividend payouts reduce the NAV of the fund.
- When goals of investment are short term and regular income is expected to full fill short-term goals.
- Dividends can be a good option for monthly income post retirement.
Advantages of dividends
From company’s view point
- Dividend distribution is an indicator of the positive financial future and strong performance of the company.
- A high-value dividend declaration reflect positively on a company and indicate that the company is doing well and has generated desired profits.
From investor’s view point
- Stable dividend payment assures investors a reliable source of income, even when the market price of the shares/stock fluctuate/dip.
- Investors reap the benefit of dividends without having to sell their stocks.
- In many jurisdictions, dividends are treated as tax-free income and so are preferred by many shareholders.
- In case company is unable to pay dividends, it may lose the trust of its shareholders, who may sell off their shares in the near term.
- Loss of pay of dividends may indicate poor financial health of the company, which may affect its repute in the market.
- Paying off dividends entails cash outflow, which it could have otherwise reinvested in growth of business.
Dividends are like redemption from own investment and they come at the cost of the NAV. So investors looking for short-term goals and regular income can go for it, but investors can go for growth option if they are looking for long term tenures as investment grows gradually over a period of time and profits are ploughed back into the fund.