A dividend is the distribution of reward from a portion of company’s earnings and is paid to a class of its shareholders. Dividends are decided and managed by the company’s board of directors, though they must be approved by the shareholders through their voting rights. Dividends can be issued as cash payments, as shares of stock, or other property, though cash dividends are the most common.
When a company earns profits from operations, management can do one of two things with those profits. It can choose to retain them – essentially reinvesting them into the company with the hope of creating more profits and thus further stock appreciation. The alternative is to distribute a portion of the profits to shareholders in the form of dividends. Management can also opt to repurchase some of its own shares – a move that would also benefit shareholders.
how companies establish dividend policy and the different types of dividend policies; the reasons why companies and investors might prefer higher, lower or no dividend payments; and share repurchases, stock splits and stock dividends as an alternative to cash dividends.
A cash dividend is money paid to stockholders, normally out of the corporation’s current earnings or accumulated profits. Not all companies pay a dividend. Usually, the board of directors determines if a dividend is desirable for their particular company based upon various financial and economic factors. Dividends are commonly paid in the form of cash distributions to the shareholders on a monthly, quarterly or yearly basis. All dividends are taxable as income to the recipients.
Dividends are normally paid on a per-share basis. If you own 100 shares of the ABC Corporation, the 100 shares is your basis for dividend distribution. Assume for the moment that ABC Corporation was purchased at $100/share, which implies a $10,000 total investment. Profits at the ABC Corporation were unusually high so the board of directors agrees to pay its shareholder $10 per share annually in the form of a cash dividend. So, as an owner of ABC Corporation for a year, your continued investment in ABC Corp should give us $1,000 in dividend dollars. The annual yield is the total dividend amount ($1,000) divided by the cost of the stock ($10,000) which gives us in percentage terms, 10%. If the 100 shares of ABC Corporation were purchased at $200 per share, the yield would drop to 5%, since 100 shares now cost $20,000, or your original $10,000 only gets you 50 shares instead of 100. If the price of the stock moves higher, then dividend yield drops and vice versa.
Like cash dividends, stock dividends and stock splits also have effects on a company’s stock price.
Stock dividends are similar to cash dividends; however, instead of cash, a company pays out stock. As a result, a company’s shares outstanding will increase, and the company’s stock price will decrease. For example, suppose Newco decides to issue a 10% stock dividend. Each current stockholder will thus have 10% more shares after the dividend is issued.
Stock splits occur when a company perceives that its stock price may be too high. Stock splits are usually done to increase the liquidity of the stock (more shares outstanding) and to make it more affordable for investors to buy regular lots (a regular lot = 100 shares). Companies tend to want to keep their stock price within an optimal trading range.
Stock splits increase the number of shares outstanding and reduce the par or stated value per share of the company’s stock. For example, a two-for-one stock split means that the company stockholders will receive two shares for every share they currently own. The split will double the number of shares outstanding and reduce by half the par value per share. Existing shareholders will see their shareholdings double in quantity, but there will be no change in the proportional ownership represented by the shares. For example, a shareholder owning 2,000 shares out of 100,000 before a stock split would own 4,000 shares out of 200,000 after a stock split.
Stock Split Example:
Suppose Newco’s stock reaches $60 per share. The company’s management believes this is too high and that some investors may not invest in the company as a result of the initial price required to buy the stock. As such, the company decides to split the stock to make the entry point of the shares more accessible.
For simplicity, suppose Newco initiates a 2-for-1 stock split. For each share they own, all holders of Newco stock will receive two Newco shares priced at $30 each, and the company’s shares outstanding will double. Keep in mind that the company’s overall equity value remains the same. Say there are one million shares outstanding and the company’s initial equity value is $60 million ($60 per share x 1 million shares outstanding). The equity value after the split is still $60 million ($30 per share x 2 million shares outstanding).
While stock prices will most likely rise after a split or dividend (remember price increases are caused by positive signals a company generates with respect to future earnings), if positive news does not follow, the company’s stock price will generally fall back to its original level. Some investors think that stock splits and stock dividends are unnecessary and do little more than create more stocks.
How Companies Pay Dividends
Dividend payouts follow a set procedure. To understand it, first we’ll define the following terms:
1. Declaration Date
The declaration date is the day the company’s board of directors announces approval of the dividend payment.
2. Ex-Dividend Date
The ex-dividend date is the date on which investors are cut off from receiving a dividend. If, for example, an investor purchases a stock on the ex-dividend date, that investor will not receive the dividend. This date is two business days before the holder-of-record date.
The ex-dividend date is important because from this date forward, new stockholders will not receive the dividend, and the stock price reflects this fact. For example, on and after the ex-dividend date, a stock usually trades at a lower price as the stock price adjusts for the dividend that the new holder will not receive.
3. Holder-of-Record Date
The holder-of-record (owner-of-record) date is the date on which the stockholders who are eligible to receive the dividend are recognized.
4. Payment Date
Last is the payment date, the date on which the actual dividend is paid out to the stockholders of record.
Example: Dividend Payment
Suppose Newco would like to pay a dividend to its shareholders. The company would proceed as follows:
1. On Jan. 28, the company declares it will pay its regular dividend of $0.30 per share to holders of record as of Feb. 27, with payment on Mar. 17.
2. The ex-dividend date is Feb. 23 (usually four days before of the holder-of-record date). As of Feb. 23, new buyers do not have a right to the dividend.
3. At the close of business on Feb. 27, all holders of Newco’s stock are recorded, and those holders will receive the dividend.
4. On Mar. 17, the payment date, Newco mails the dividend checks to the holders of record.
• Gitman, Lawrence J., and Chad J. Zutter. Tenth Edition. Principles of managerial finance