What is a dividend?
Dividend is the payment that a company makes to shareholders as part of their rewards for holding shares in the company. This payment is usually made from the earnings of a company in a particular period. However, dividend is dependent on a company’s earnings. This means that a company may choose not to pay dividends in a particular year if its performance is not impressive. However, there is a class of stocks that entitle its holder a guaranteed dividends every year. This type of stocks is called preferred stocks. Preferred shareholders enjoy fixed income every year. It does not matter whether a company makes profit or not. For this reason, if a company records a loss in a particular year, it may need to pay the preferred shareholders from its reserves. But in a period of surplus, only common stockholders are entitled to increased dividends.
Besides the problem of poor performance, there are other reasons why a company may choose not to pay dividends. If the company is faced with liquidity or cash flow problem, the company may not be able to pay dividends to its shareholders. Profitability is not the same thing as liquidity. A company may be profitable and at the same time not liquid. This happens when a company is unable to manage its working capital effectively. For instance, if a company has to pay its suppliers with no or short credit term and the customers do not pay for what they buy on time. There will be liquidity gap. Also, a company may choose not to pay dividends because it wants to use the available cash to finance its growth. If a company is expanding, it will definitely need funds for such project. It may not make sense to pay out dividends and start sourcing for loans at high interest rates. Since the goal of any company is to ultimately enhance the worth of its shareholders, the company may reinvest its profits in order to create more wealth to its shareholders. In a company like this, the shareholders’ rewards may come in form of capital appreciation. Any shareholder that wants immediate income may choose to sell part of its stocks. This is like a shareholder declaring his own dividends. Shareholders can achieve this by selling part of their stocks at profit when the price has increased.
Nevertheless, a company may still want to reward or impress its shareholders. For this reason, the company may declare stock dividends instead of cash dividends. I will explain these two types of dividends below:
Types of Dividends
Cash Dividends: This involves payment of money from the earnings a company makes to its shareholders. This usually reduces the cash available for the company to finance its operations or expansion projects. The amount an individual shareholder will receive as dividends will be based on the number of shares he holds in the company. Some investors may like to buy stocks of companies that pay dividends regularly as a way of earning a secondary income. For example, a retiree who no longer receives pay checks may like to invest in stocks of dividend paying companies. This will help him generate passive income.
Stock Dividends: If a company is not paying cash dividends and still wanting to impress its shareholders, the company may distribute stocks to its shareholders. In this regards, the existing shareholders will get new additional stocks without having to pay for it. Stock dividend is usually issued to existing shareholders based on their current holdings in the company. Stock dividend can also be called bonus issue. For example, if a company declares a stock dividend of one to five, it means that every existing shareholder will get one additional new share for every five shares he is currently holding. A shareholder having 5,000 shares will receive additional 1,000 shares, thereby increasing his total number of his shares to 6,000 shares.
Other Dividend Terms
Dividend stocks: These are stocks of companies that consistently pay good dividends to their shareholders every year. These companies are usually stable. They have strong and growing earnings. Dividend stocks are attractive to retirees or people seeking second source of income.
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Dividend yield: Dividend yield formula is the dividends per share divided by the current stock price. Investors use dividend yield to measure the returns on their income stocks in comparison to other investments. While stocks with high dividend yield may look attractive, it has to be traded with caution. A stock with high dividend yield may not necessarily mean that it is good stock to buy. A fall in stock price will make the dividend yield to increase. At times, a fall in the price of a stock may be a signal that the company is having trouble. If you want to invest in companies with high dividend yield, it will be good for you to look at the past price trends. Also, you need to ensure that the stocks have good fundamentals. Let’s look at how dividend yield is calculated. If a company declares a dividend per share of $5 while the stock trades at $100 per share, the dividend yield will be 5%. That is, dividends per share divided by the share price. But let’s assume that the price of the stock fall to $50 and the company still pays $5 per share. The dividend yield will increase to 10%. The high dividend yield of 10% may appeal to new investors because they will be able to buy the stock cheap. But to existing shareholders, the higher dividend yield may not mean any difference.
Dividend aristocrats: These are dividends stock companies selected from S&P 500 based on their continuous increase in the amount of dividends they pay in the past 25 years. Before any company can be classified as dividend aristocrats, it is not enough to pay high dividends. It must have demonstrated strong earnings growth with healthy liquidity that will support the payment of the dividends and still be able to finance its growth without stress. Dividend aristocrats are selected from different sectors such as consumer goods, information technology, financials, industrial and healthcare etc. So, your preference for a particular sector may still influence the dividend aristocrats you should buy their stocks. However, such stocks must be a member of S&P 500.
Dividend payout ratio: Dividend payout ratio is simply the amount of dividend that a company pays its shareholders in relation to the earnings of the company. It is calculated by dividing the dividends that a company pays to its shareholders by its total net income. Alternatively, you can achieve the same result by dividing the dividends per share by the company’s earnings per share. This is usually expressed as a percentage. If a company has a high dividend payout ratio, it means that it pays greater percentage of its earnings to its shareholders. While stable companies with less potential for growth may afford to maintain a high dividend payout ratio, new companies or emerging markets may not be able to do this. High dividend payout ratio means having less funds available to finance the growth of the company. If a company’s income is $1m and it declares dividends of $550,000, the dividend payout ratio will be 55%. A dividend payout ratio of more than 60% may be considered to be high. The lower the ratio, the more funds the company will have available to finance its research, growth and expansion.
Dividends per share: This is expressed as total dividends a company pays its shareholders divided by the number of its outstanding shares. The total dividends a company pays may not be relevant to the shareholders but to the paying company. What is relevant to the individual shareholders is the dividends per share. Let’s consider the example of the two companies below:
- Company “A” declares a dividend of $100,000 while its outstanding shares equal 50,000 shares. Then the dividends per share will be $2.00
- Company “B” declares a dividend of $200,000 while its outstanding shares equal 400,000 shares. Then the dividends per share will be $0.50
Ordinarily, if you compare the total dividends declared by the two companies, company “B” may look attractive. But as an investor, your focus should not be on the total dividends a company declares. What should attract you is the amount that you are getting from the dividends declared. Supposing you have 1,000 units of shares from each company, you will get dividends of $2,000 and $500 from Company “A” and Company “B” respectively. These figures are arrived at by multiplying the numbers of shares you have in each company by their dividends per share. You will agree with me that Company “A” is more attractive.
Dividend Calculator: This is a tool that investors can use to calculate the amount they could make by investing a particular amount in dividend paying stocks if compounded over a certain period of time. Dividend Calculator assumes that you know the dividend yield of the stocks you invest in. If you don’t know it, you can get this from the website of the companies you bought their shares or that you want to buy. It is also assumed that you will re-invest your dividends in order to tap into the benefits of compound interest. There are dividend calculators that will allow you to compound your dividends monthly, quarterly or annually depending on the frequency of the dividends.
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Dividend calendar: This helps you in monitoring the list of companies paying dividends at a specific date. This will guide you on the right time to buy a stock in order to qualify for dividends.
Ex-Dividend Date: If anyone buys stocks at Ex-dividend date, the person will not be entitled to the dividends that have been declared even though the dividends have not been paid. If you want to enjoy dividends declared by a company, you will need to buy the stocks before the Ex-dividend date. But if you miss the dividends, all is not lost. The price of stocks usually drops by the dividend per share on the actual Ex-dividend date. If you buy a stock before the Ex-dividend date, it means you buy the stock cum-dividend. This means you will be entitled to the payment of dividends.
Dividend tax rate: When you are paid dividends, it is recognised as part of your income. The rate of tax that is applicable to the dividends you receive is regarded as dividend tax rate. This rate depends on your income bracket. But if you receive a qualified dividend, the capital gain tax rate may be applied. A dividend is qualified if you are a shareholder of an American Corporation, a foreign company incorporated in a United States Possession or any foreign company that enjoys a United States tax treatment. In addition, you must hold the stocks for at least 61 out of 121 days starting from 60 days before the last ex-dividend date.
Dividend history: This is the aggregation of the past dividends that a company paid over a number of years. For instance, NASDAQ provides this free to the general public on their website. You can view the dividend history of any company by entering its symbol. Most listed companies display their dividend history on their website under the investors’ relation page. Investors will be able to see whether a company has increased its dividend payments over time.