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What are Dividends?
Dividends are defined as the distribution of a portion of a company’s earnings to certain shareholders of its stock. When a company makes a profit, a share of those profits can be put aside as retained earnings for reinvestment into the company’s business and the rest paid out to shareholders in the form of a dividend.
Unlike corporate bonds that obligate the issuing company to pay a contracted amount or be in default, dividend payouts depend on decisions made by the company’s senior management and board of directors, so they are not guaranteed.
Depending on underlying circumstances, the company’s managers and directors can choose to reduce or completely eliminate dividend payments at any time. The main types of dividends are:
- Cash dividends: Companies generally pay dividends on a quarterly basis as a way for shareholders to participate in the profits and growth of the business. U.S. stocks typically distribute cash dividends, for example, if a shareholder owns 100 shares of stock and the company pays out a $0.50 quarterly dividend, the shareholder would receive $50 each quarter for every 100 shares owned. Cash dividends can be disbursed as checks mailed to shareholders, or they can be directly deposited into the shareholder’s brokerage account.
- Stock dividends: Stock dividends consist of dividends paid out as additional stock. For example, if a shareholder owns 100 shares and the company declares a 10% dividend in stock, then the shareholder would receive an additional 10 shares for the 100 shares they originally owned. This would turn their 100 shares into 110 shares.
- Special dividends: If a company has had an exceptionally good quarter or wants to alter their financial structure, they might decide to issue a “special dividend”. This type of dividend generally consists of cash paid out on top of the company’s usual dividend. Such special dividends are often larger than the company’s normal quarterly dividend.
- Asset dividends: A company’s assets can also be distributed to shareholders as a dividend. While this type of distribution is rare, companies can pay out assets such as real estate, physical assets or investment securities as a dividend to shareholders.
In addition, some companies might offer miscellaneous non-traditional assets as dividends, such as shares of a newly spun off company for example. Other types of dividend payments include warrants, convertible debentures and stock options.
How Dividends Work
The way that most publicly traded companies operate when it comes to paying out dividends typically involves several steps as follows:
- Make a profit: A company typically first needs to generate a certain amount of profit from its gross revenue to consider a distribution of dividends to stockholders practical.
- Management decision: Once a company has obtained a certain amount of capital from profits, the company’s management decides on the amount to be distributed to shareholders.
- Board approval: Dividend payments need the approval of a company’s board of directors. The dividend amount is determined on a per share basis and is paid out equally among all shareholders of a stock class, such as common or preferred stock.
- Dividend announcement: A company declares that its dividend will be paid on a certain date, which is known as the payable or payment date.
- Dividend payment: The dividend is paid on the ex-dividend date, and the dividend amount is deducted from the company’s stock price at the opening of trading on that day.
Traders and investors who have borrowed a stock to go short must pay any dividends received to the stock owner who lent them the stock. The dividend amount is therefore first received from the company and then deducted from a short seller’s account on the ex-dividend date in order to be paid to the owner of the borrowed stock.
Corporations that pay dividends generally use four dates to determine which investors will receive dividends, when the investors have to be on the company’s books, and when the dividend will be received. These dividend dates are as follows:
- Declaration date: This is the date that the company declares the payment of the dividend to stockholders at a future date.
- Ex-dividend date: On this date, the company determines which of its shareholders have the right to receive the dividend. The ex-dividend date is typically one business day before the record date, which ensures that the shareholder that receives the dividend owns the stock for a full one business day prior to receiving the dividend.
- Record date: The record date is set by the company’s board of directors and is the day when shareholders must own the stock and have their ownership recorded on the company’s books in order to receive the dividend when it is disbursed.
- Payable date: The payable or payment date is when the dividend funds are disbursed to shareholders of record.
Why Companies Pay Dividends
The cash assets of a profitable company need to be allocated in a certain way if the company desires a balanced allocation of assets. This can be done either through reinvestment into the company’s business or distribution to shareholders in the form of a dividend.
A company pays dividends if its management wishes to disburse its excess cash to shareholders rather than holding onto it for other business purposes.
Some good reasons for paying dividends to shareholders include maintaining the interest of current investors and attracting the interest of new ones. Paying dividends also provides investors in the company with an attractive income on their investment and can provide support for the company’s stock price.
Why Companies Don't Pay Dividends
Many companies refrain from paying dividends for a variety of reasons. For example, if the company has plans to acquire another firm to expand its business, then accumulation of its profits as retained cash holdings could suit the company better than paying shareholders a dividend.
Furthermore, a company may decide to use its excess cash to buy back its own shares instead of paying a dividend. This reduces its stock float, adds value to existing shares and increases its earnings per share (EPS).
Also, if the company needs to invest cash in its business or pay off existing debt, then paying out a dividend to shareholders may not be prudent.