When you invest in the stock market, one of the ways you can earn returns on your investment is through dividends. A dividend is a portion of a company’s profits that is distributed to its shareholders. These payments are usually made quarterly and can take the form of cash or reinvestment in additional stock.
The decision to pay dividends is made by the company’s board of directors. The amount of the dividend is usually expressed as a dividend yield, which is calculated by dividing the dividend per share by the company’s share price. For example, a dividend yield of 2.5% means that for every share you own, you will receive 2.5% of the share price as a dividend payment.
To be eligible to receive a dividend payment, you must own the stock before the ex-dividend date. This is the date on which the stock begins trading without the dividend, and anyone who buys shares on or after this date will not be eligible to receive the upcoming dividend payment.
Why is understanding dividends so important ?
In the world of finance, dividends represent a way for companies to reward their shareholders for investing in their equity. Shareholders must vote in favor of dividends for them to be approved. Dividends are typically given out in the form of cash, but they can also be paid out as shares of stock. Additionally, certain mutual funds and exchange-traded funds (ETFs) also provide dividends to their investors.
Dividends generally originate from a company’s net profits. While businesses can opt to keep their profits as retained earnings for future investments, they can also allocate a portion of their earnings to shareholders as dividends.
Sometimes, companies may distribute dividends despite having insufficient profits to support their past payout history.
The board of directors has the authority to determine the payout rates and the duration of dividend payments. Dividends can be paid at regular intervals, such as monthly, quarterly, or annually. For instance, Walmart Inc. (WMT) and Unilever (UL) disburse regular quarterly dividends.
Furthermore, companies may issue one-time special dividends, either as a stand-alone or in addition to their standard dividend. On February 18, 2022, United Bancorp Inc. announced a special dividend of 10 cents per share.
Companies that offer regular dividends to their shareholders are often larger and more established, with predictable profits. In fact, the following industry sectors are known for their consistent record of dividend payments:
Additionally, companies structured as master limited partnerships (MLPs) and real estate investment trusts (REITs) are required to distribute a specified portion of their earnings to shareholders. Certain funds also issue regular dividend payments in accordance with their investment objectives.
However, startups in industries such as technology or biotech may not offer regular dividends. This is because these companies are often in their early stages of development and choose to retain earnings for research and development, business expansion, and other operational activities.
Understanding Important Dividend Dates
When it comes to receiving dividend payments from companies, it’s important to be aware of the specific dates involved in the process. Each event follows a specific order, and knowing which shareholders qualify for the payment is critical.
- The announcement date, also known as the declaration date, is when company management publicly announces the dividend. However, before the payment can be made, shareholders must first approve it.
- The ex-dividend date refers to the date on which a shareholder’s eligibility to receive the dividend expires. Suppose a stock has an expiration date of Monday, May 5th. In that case, shareholders who purchase the stock on or after that day will not qualify for the dividend.
- On the other hand, shareholders who own the stock on Friday, May 2nd, or earlier will be eligible for the distribution.
- The record date is a cutoff date determined by the company to identify which shareholders are qualified to receive the dividend or distribution. Shareholders who are registered as owners of the stock on this day are considered eligible.
- Once the record date has passed, the company issues the payment of the dividend on the payment date. This is when the money gets credited to investors’ accounts.
Understanding the Impact of Dividends on Stock Prices
Dividends are a common way for companies to distribute a portion of their profits to shareholders. They can impact the share price of a company in different ways, depending on the market’s perception of the dividend payment and the company’s financial situation.
To illustrate this, let’s take the example of a company trading at $60 per share that declares a $2 dividend on the announcement date. The announcement of the dividend can create positive sentiment among investors, leading to an increase in demand for the company’s shares. Consequently, the share price may increase by $2 and reach $62.
However, the impact of dividends on stock prices may vary depending on the ex-dividend date. The ex-dividend date is the day on which a stock begins trading without the right to receive the upcoming dividend payment. For instance, if the stock trades at $63 one business day before the ex-dividend date, it will be adjusted by $2 and start trading at $61 at the beginning of the ex-dividend date’s trading session.
This is because anyone who purchases shares on the ex-dividend date will not receive the dividend payment. Therefore, the stock price may adjust downward to reflect the reduction in value due to the dividend payment.
Why do companies distribute dividends?
Shareholders often anticipate receiving dividends as a form of compensation for their investment in a company. Dividend payouts have a positive impact on a company’s reputation and help to maintain investors’ confidence.
A company’s announcement of a high-value dividend distribution can be an indication that it is thriving and has generated substantial profits. However, it may also suggest that the company lacks viable projects to generate better returns in the future. In this case, the company is using its funds to pay shareholders instead of reinvesting them to foster growth.
When a company with a long-standing record of dividend payments reduces the dividend amount or eliminates it altogether, it could signal to investors that the company is experiencing difficulties. For instance, on February 1, 2022, AT&T Inc. halved its yearly dividend to $1.11, and its shares plummeted by 4% on that day.
However, a decrease in dividend amounts or a decision not to pay dividends may not necessarily spell bad news for a company. The management may have a well-thought-out plan for utilizing the funds. For instance, they may have identified a high-yield project that has the potential to magnify returns for shareholders in the long run.
Understanding Fund Dividends
When it comes to dividends, it’s important to note that funds such as bonds or mutual funds operate differently than companies. Fund dividends are determined using the net asset value (NAV) principle, which reflects the valuation of their assets or the price of the holdings in their portfolio.
It’s important to keep in mind that regular dividend payments do not always indicate outstanding fund performance. For example, a bond-investing fund may pay monthly dividends as a result of the monthly interest earned from its interest-bearing holdings, and the income is merely transferred to the fund’s investors either fully or partially.
On the other hand, a stock-investing fund pays dividends based on the earnings received from the many stocks held in its portfolio or by selling a certain number of stocks and distributing the capital gains to its investors.
Is dividend policy really insignificant?
According to economists Merton Miller and Franco Modigliani, a company’s dividend policy has no impact on the price of its stock or its cost of capital. They argue that a shareholder’s reaction to a company’s dividend policy may be neutral, even in cases where the company offers high dividends. The investor can use the cash received to purchase additional shares, effectively maintaining the total value of their investment.
Alternatively, if a company’s dividend payout is low, the investor can sell shares to generate the cash they require, again maintaining the value of their investment. Therefore, Miller and Modigliani conclude that dividends are irrelevant and investors need not worry about a company’s dividend policy as they can synthetically create their own.
Despite this, dividends continue to serve as an attractive investment incentive, providing shareholders with additional earnings.
A Guide to Investing in Dividend-Paying Securities
If you are interested in investing in securities that pay dividends, there are various options available to you. Some of the options include stocks, exchange-traded funds (ETFs), and mutual funds. When it comes to selecting stock investments, you can use either the dividend discount model or the Gordon growth model. These models utilize estimated future dividend payments to determine the value of shares.
To compare the dividend payment performance of multiple stocks, you can use the dividend yield factor. This metric measures dividends as a percentage of a company’s current market price per share.
Apart from dividend yield, you can also use the total return factor as an essential performance measure to assess the returns generated from a particular investment. This measure takes into account interest, dividends, and increases in share price, among other capital gains.
When investing in dividend payments, tax implications are a crucial factor to consider. If you are in a high tax bracket, you may prefer investing in dividend-paying stocks, especially if your jurisdiction allows for a zero-or-lower tax on dividends. For instance, Hong Kong has tax-exempt dividend gains, while Greece and Slovakia offer lower taxes on dividend income for shareholders.