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What is a Dividend?
A dividend can be described as a reward that publicly-listed companies extend to their shareholders, and its source is the company’s net profit. Such rewards can either be in the form of cash, cash equivalent, shares, etc. and are mostly paid from the remaining share of profit once essential expenses are met. A company’s board of directors decides the rate of dividend, wherein, the approval of majority shareholders is also factored in.
However, companies may decide to retain their accumulated profits to reinvest in the business or reserve it for future use. Further, announcements about dividend income declaration mostly accompany a significant increase or decrease in the company’s stock value.
Types of Dividend
A company may pay a dividend to its shareholders in different forms. Similarly, depending on the frequency of declaration, there are two major types of dividend that shareholders are rewarded with, namely –
- Special dividend: This type of dividend is paid on common stock. It is often issued under a particular circumstance when a company has accumulated substantial profits over several years. Mostly such profits are looked at as excess cash that does not need to be used at the given moment or in the immediate future.
- Preferred dividend: Such a dividend is issued to the preferred stock owners and usually accrues a fixed amount that is paid quarterly. Also, this kind of dividend is earned on shares that function more like bonds.
Besides these, the list below highlights the most common types of dividend.
Most companies prefer to pay a dividend to their shareholders in the form of cash. Usually, such an income is electronically wired or is extended in the form of a cheque.
Some companies may reward their shareholders in the form of physical assets, investment securities and real estates. However, the practice of offering assets as dividends is still quite rare among companies.
A company offers stocks as dividends by issuing new shares. Typically, the stock dividends are distributed on a pro-rata basis, wherein, each investor earns dividend depending on the number of shares he/she holds in a company.
- Common stocks
Typically, it is the profit that is paid to the common stockholders of a company from its share of accumulated profits. The share of this dividend is often decided by the law, especially when the dividend is set to be paid in cash and may lead to the company’s liquidation.
Other than these, a company may decide to offer shares of a new company, warrants and other financial assets as a dividend. Nonetheless, it must be noted that dividend income tends to influence a company’s share price accordingly.
It must be noted that paying dividends to shareholders may not influence the overall value of the business venture. Regardless, such a move tends to lower the overall equity value of the venture by the exact amount that is being paid as a dividend. To further elaborate, dividend once paid out goes debited from the accounting books permanently and is an irreversible move.
Further, when a company declares a dividend, its share prices undergo a significant increase governed by market activities. They are more likely to pay a premium in the hope of earning dividends. However, the share prices start to decline by a similar proportion once the date of dividend eligibility expires. Such a fall usually occurs when new investors are not deemed eligible to receive dividend and are hence reluctant when it comes to paying the associated premium.
Similarly, if the market is anticipated to remain optimistic until an ex-dividend date, the increase in stock’s value may be higher than the dividend offered. Irrespective of reductions, such an occurrence often leads to an increase in the overall value of a company’s stock.
Regardless, to understand the impact of dividend declaration on stock prices individuals need to become familiar with the important dates about dividends.
For instance, the table below highlights the most important dividend dates.
|Announcement dates||The company’s board of directors announces the dividend on this date.|
|Ex-dividend date||On this date, the dividend eligibility is slated for expiry.|
|Record date||Typically, it is the cut-off date when a shareholder’s eligibility income is scrutinised.|
|Payment date||On this date, the dividend is credited to investors’ respective accounts.|
How is Dividend Income Calculated?
A dividend is calculated by using the dividend payout ratio, wherein, the annual dividend per share is divided by earnings per share. The said ratio can be expressed as –
Dividend Payout Ratio = Dividends paid / Reported net income
Notably, the dividend payout ratio is 0% for those companies who do not offer dividends to their shareholders. Similarly, companies who pay out the total net income as dividends have 0 dividend payout ratio.
Similarly, the retention ratio can be computed by dividing the dividend paid per share with earnings per share. The same can be expressed as –
Retention Ratio = Dividend per share / Earnings per share
With the help of the dividend payout ratio, one can conveniently find out the amount of money a company is offering to its shareholders. Further, the ratio comes in handy to calculate the amount that is reinvested for expanding and improving a company’s operations, paying off existing debt or building a cash reserve.
It also proves useful in assessing a company’s sustainability. For instance, a company with a payout ratio that is more than 100% signifies that it is paying off more than what shareholders are earning. Eventually, such a practice would force a company to either reduce their offering or stop it altogether. On the other hand, a company with a steady dividend payout ratio indicates a robust financial standing.
How do Dividends Work?
The steps elaborated below highlight how dividends work –
Step 1 – Publicly-listed companies generate substantial income and accumulate a significant share of retained earnings.
Step 2 – A company’s management decides if they should reinvest their retained earnings or distribute the same among shareholders.
Step 3 – The board members on availing major shareholder’s approval declare dividend on a company’s shares.
Step 4 – Important dates related to dividend declaration are announced.
Step 5 – Shareholder’s eligibility to earn dividend is scrutinised.
Step 6 – The dividend is paid to shareholders.
Conversely, business owners may decide to reinvest the excess earnings into their business to expand their operations or overall productivity. Subsequently, it must be noted that both retaining and paying off dividends tend to influence the financial model of a business venture.
Dividend and Financial Modelling
A dividend is not treated as an expense; instead, it is considered to be an allocation of a company’s retained earnings. Since paying out dividends tends to impact a company’s total equity, it directly influences the entity’s financial modelling. The table below highlights how dividends affect a company’s financial statements.
|Balance Sheet||When paid out, it reduces aggregate cash and retained earnings.|
|Cash Flow Statement||It is reported as a use of cash under the financing activities section.|
|Statement of Retained Earnings||Here, it is reported as a decrease in retained earnings.|
|Income Statement||No impact.|
Dividend stocks can be defined as those publicly-listed companies which offer regular dividends to their shareholders. Such companies are mostly well-established and tend to possess a fair record of allocating earnings to their shareholders.
Things to consider for choosing a profitable dividend stock –
- The company stock should at least have a dividend payout ratio of 50%.
- Overall dividend yield should be between 3% and 6%.
- The company should have a fair track record when it comes to offering dividend and paying off debts.
Keeping these pointers in mind, along with other financial parameters, will help gauge a company’s profitability and financial standing effectively.
Dividend Payout Ratio vs Dividend Yields
A dividend payout ratio tends to indicate the portion of a company’s net earnings that are offered as dividend income. Similarly, a company’s dividend yield highlights the rate of returns that were made available to the shareholders in the form of cash dividends.
Regardless, dividend payout is regarded to be a more useful indicator of a company’s ability to allocate dividend among its shareholders sustainably. Also, it is largely associated with a business venture’s cash flow and further highlights the amount it has paid as dividends in a year. Notably, even the slightest increase in share prices tends to lower the rate of dividend yield significantly.
Consequently, the dividend yield is calculated using the given formula.
Dividend Yield = Annual dividends per share / Dividends per share
Lastly, it can be said that potential investors who wish to invest in high-dividend yielding stocks must become familiar with the concept of dividend beforehand. Successively, they should take into account the various factors and associated financial parameters for gauging the scope of generating profits by investing in such stocks. Make sure to check the dividend stock list for different shares before finalising investment.