What are Dividends?
Dividends are payments that publicly-listed companies or funds make to their shareholders as a reward for their investment in the company. Companies will usually pay dividends in cash to common and preference shareholders, but payments of shares of stock or property also occur.
The vast majority of individuals or organizations that own shares in a company have common shares. Common shareholders usually have the right to vote on certain company decisions, to receive common dividends declared and will receive the residual value of the assets.
Preferred shareholders enjoy more rights than common shareholders. They often receive dividend payments at regular intervals. Usually, preferred stock is issued at par value and its dividend is calculated as a percentage of value.
The board of directors manages dividends, but shareholders must approve the distribution through votes. In most cases, if a company does not have a healthy retained earnings account, it will not pay dividends.
For companies, it is less tax efficient to pay dividends than buying back stock if capital gains taxes are lower than income taxes. That is the reason Berkshire Hathaway doesn’t pay dividends.
Key Learning Points
- A dividend is a distribution of a company’s profits to its shareholders
- The size of the dividends depends on various factors and is at the discretion of its Board of Directors
- A company early in its lifecycle will typically reinvest profits back into the business and will only start paying dividends when it matures
- Dividend payments are reported as a cash outflow in the “cash flow from financing activities” section of a company’s cash flow statement
- The dividend yield and dividend cover ratios are two common metrics used to help analyze a company’s dividends
- It is possible to value the equity of a business by discounting future expected dividend payments
The size and timing of dividends are decided by the board of directors and depends on several factors, including:
- The company’s earnings
- Its financial position (its debt payable or the state of cash reserves)
- Business development needs (if it needs cash for any capital expenditures)
- Regulatory considerations (e.g., if the company is facing lawsuits and needs to preserve cash to deal with any unfavorable outcomes)
- The company’s stage in its (mature companies are likely to pay dividends while growing companies prefer to retain their earnings for reinvesting in future growth)
Dividends – Key Terminology
When dividend payment happens, cash goes down and so does equity. As such dividends reduce the equity value of a company and therefore the share price. This happens at the ex-dividend date, described below.
Dividend Announcement, or Declaration, Date
This is the date at which the company announces its next dividend. This usually happens when earnings are reported. Dividends could be paid annually, semi-annually, or quarterly.
The ex-dividend date is the first day when shares are trading without the right to the announced, upcoming dividend. On this date, the share price, all else equal, will fall by the same amount as the upcoming dividend.
Dividend Record Date
This is the date on which an investor must be recorded as an owner of shares to receive the next dividend. Because most shares settle T+2 the dividend record date is usually one day after the ex-dividend date. This ensures investors that bought the share before the ex-dividend date will be registered as shareholders on the record date.
Dividends – Key Ratios
Dividends are important to investors as they are cash returns on the investment. When assessing a company based on its ability to pay dividends, investors look at two ratios:
- Dividend yield
- Dividend cover
The dividend yield analyses the relationship between a company’s stock price and the amount of dividend it pays each year. It is calculated as dividends / share price.
Note that high dividend yields do not always indicate attractive investment opportunities. A suppressed stock price may increase the dividend yield.
Dividend cover, or dividend coverage ratio, indicates a company’s capacity to pay dividends from the profit attributable to shareholders. It is calculated as Net Income / Dividends. Dividend cover helps in assessing the sustainability of a company’s dividend payments.
Dividend Discount Model (DDM)
While an ordinary DCF valuation uses Free Cash Flows to value the EV of a business and then backs out implied equity value, the DDM uses future expected dividend payments to value the equity of a company directly.