What Are Dividends?

by | Apr 9, 2021

Dividends are cash payments paid to the shareholders of a company. These cash payments are usually pulled from the company’s earnings. While the majority of a company’s earnings or profits are retained to fund current and future business activities a portion may be used to pay a dividend.

Types of Dividends

To be entitled to a company’s dividends you usually need to be a holder of the company’s common stock. There are several ways a dividend can be paid out.

  1. Cash dividends. This is the most common way for a dividend to be paid out. The company will transfer money to the shareholder’s brokerage account.
  2. Stock dividends. Instead of being paid in cash, the shareholder will receive additional shares in the company.
  3. Special dividends. A special dividend is a once-off occurrence where additional profits are distributed to shareholders. 
  4. Preferred dividends. A preferred dividend is paid to the owner of companies preferred stock. Preferred stock can be thought of as a hybrid between a share and a bond. The amount paid for a preferred dividend usually remains constant over time. 

What is a Dividend Reinvestment Plan (DRIP)?

A dividend reinvestment plan or DRIP is a plan which tells the company that instead of being paid a dividend in cash you want the company to instead use that cash to purchase more shares of the company. You will usually receive a discount on the market share price when you opt into a dividend reinvestment plan. 

Why Do Companies Pay Dividends?

A company may choose to pay a dividend if they have no better use for their earnings. Usually, a company will retain earnings to maintain its current business operations. It will also retain earnings to grow and expand its business. If the company believes it will receive little return on its investment by growing the business it may choose to pay shareholders so that they can generate their own returns. 

Dividends are more likely to be paid from a well-established company rather than a newly established one. Well established companies will have grown large already and any future growth will be slow. These companies will have an abundance of cash and so will likely pay their shareholders a dividend.

New companies on the other hand have lots of room to grow and growth is fast. The problem for new companies is that it takes a lot of cash to fund this growth. New companies will want to retain all of their earnings so that they can grow as fast as possible. Paying a dividend during the early stages of a business will only slow growth hurting both the company and its investors.

Dividends may also be paid out as a reward to investors. Investors give their trust and hard-earned money to a company so they expect something in return.

One other reason a company may choose to pay a dividend is that they always have. Some investors choose to invest in companies purely for the dividend. If that company then decides to cut or cancel their dividend investors may choose to sell the stock driving the price down. A cancelled or decreasing dividend can be a sign that the company is in trouble. 

Why Might a Company Choose not to Pay a Dividend?

As already mentioned a newly established company may choose not to pay a dividend because they can put the cash to better use growing the business. If a company can put their retained earnings to work growing the company at a high rate this will be beneficial for both the company and the shareholders. 

Another reason a company may choose not to pay a dividend is that they can’t afford to. If a company cannot generate an excess of cash then it won’t be able to pay a dividend. 

Why do Investors Like Dividends?

Investors like dividends because it is the most straightforward way for them to earn a return on their investment. The investor doesn’t even have to do anything. Once they have invested in a dividend-paying company they will receive the dividend in their account without lifting a finger.

Dividends also provide investors with choice. When a company retains its earnings the investor has no say on how they are spent. When earnings are paid out to the investor through a dividend the investor can spend that however they like. They can use it to purchase more shares in the company, they can buy shares in a different company, they can buy a new car with it. It’s their money and they can spend it however they like. 

Another reason investors like dividends is that they can be used to supplement their income or even fund their retirement. Say an investor has 10,000 shares in a stock paying a dividend of $4 per share. They will generate $40,000 per year before tax. 

In certain countries, dividends are taxed at a lower rate than income and capital gains, in some countries they are even tax-free such as Hong Kong. 

Why Investors Don’t Like Dividends

When you are paid a dividend the cash will likely be transferred into your bank account. Some investors don’t like dividends because they must then go and find a use for that money. Some investors would prefer that the company just retains the earnings and puts the money to use themselves. 

Another reason investors don’t like dividends is that they are not guaranteed. At any time a company may choose to cut or cancel their dividend. Imagine you are a retiree who is living on their dividend income. What would you do if your source of income was cut because a company cancelled their dividend? Because dividends are not guaranteed investors may choose to invest in a more reliable income source such as bonds. 

Important Dates for Dividend Investors

When it comes to dividends there are some key dates you need to remember. 

Ex-Dividend Date: The ex-dividend date is the cutoff for when an investor is eligible for the next dividend payment. For example, if the ex-dividend date is on the 4th of May you must have purchased shares on the 3rd of May or before to be eligible for the next dividend.

Record Date: The record date is usually 1 day after the ex-dividend date. This is because stocks settle 2 days after you purchase them (T+2). For example, if the ex-dividend date is the 4th of May the record date will be on the 5th. If you buy stock on the 4th of May you won’t be the recorded owner of that stock until the 6th. 

All you need to remember is that if you want to be eligible for a dividend payment you must have bought it on market 2 days before the record date.

Payment Date: The day the company pays the dividend. 

How Often Do Companies Pay Dividends?

In the United States companies usually pay a dividend quarterly (every 3 months).

In Australia, dividends are paid twice a year. An interim dividend and a final dividend.

Companies and countries are not limited to this however and can pay dividends more or less frequently.

What is Dividend Yield?

The dividend yield is a measure of the company’s yearly dividend divided by the stock price of the company on a certain date. It tells you the return you will get from a stock based on its current dividend and price. For example, a company pays a dividend 4 times per year of 50c each. The yearly dividend will be $2. Now let’s say that the price of the stock today is $100. The stock will have a dividend yield of 2%.

Dividend Yield

What is the Payout Ratio?

The payout ratio is the percentage of companies net income that is paid out as a dividend. For example, a company has a net income of $100 billion. If they pay $20 billion annually in dividend they will have a payout ratio of 20%. The net income can also be calculated as the dividend per share divided by the earnings per share.

Payout Ratio

The dividend of a company with a low payout ratio will have more room to grow than a company with a high payout ratio. A higher payout ratio could also lead to the dividend being cut or cancelled. If earnings decrease the company won’t have enough cash to pay out the high dividend. 

Summary

  • Dividends are cash payments paid to the shareholders of a company.
  • There are several ways a dividend can be paid out.
    1. Cash dividends. 
    2. Stock dividends. 
    3. Special dividends. 
    4. Preferred dividends. 
  • A dividend reinvestment plan or DRIP is when you instruct the company to use your cash dividend to purchase more shares in the company. 
  • Companies pay dividends for several reasons.
    1. They have no better use for their earnings
    2. As a reward to investors
    3. They have always paid a dividend
  • A company may choose not to pay a dividend for two main reasons 
    1. The money will produce a better return by using it to grow the company.
    2. They don’t have enough money to pay one
  • Investors like dividend because:
    1. they don’t have to do anything to receive them
    2. They can be spent however the investor chooses
    3. They can be treated under lower or no tax rules. 
  • Investors may not like dividend because:
    1. They will need to be reinvested
    2. They are not guaranteed
  • There are 3 important dates to remember when it comes to dividend 
    1. The ex-dividend date
    2. The record date
    3. The payment date
  • Companies will usually pay a dividend 4 times a year in the US and twice a year in Australia. 
  • The dividend will tell you the return of a stock based on its current dividend and price.
  • The payout ratio will tell you how much of a net income is paid out as a dividend.

For more on dividends you can read the following.

Dividend Definition (investopedia.com)

What Is a Dividend and How Do They Work? – NerdWallet

Explainer: What are Dividends? | Canstar

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