What is a dividend?

What is a dividend?

Dividend is a payout by companies to its shareholders to distribute a portion of a company's earnings. According to the Corporate Finance Institute’s (CFI) dividend definition:

“A dividend is a share of profits and retained earnings that a company pays out to its shareholders. When a company generates a profit and accumulates retained earnings, those earnings can be either reinvested in the business or paid out to shareholders as a dividend.”

In other words, when a firm earns a profit it's able to put those earnings back into the company (retained profit) and pay the rest to its shareholders. A fixed amount per share is designated to a dividend and shareholders acquiring a payout in proportion to their holdings.

Dividends are chosen by the board of directors and can be issued in the form of shares, cash payment or property. 

Key takeaways

How do dividends work?

Dividends are mainly referred to by the dividend rate or the dividend yield. The dividend rate can be quoted in the form of the dollar amount that each share is allocated, and the dividend yield is quoted as the percent of the current market price. 

The net profit of a company can be distributed to the shareholders in the form of company dividends, and it can also be reinvested in the company as retained earnings – a company can also choose to do both if it wishes. 

The repurchasing of a company’s own shares in the open market is also a possibility and is known as a share buyback. Both share dividends and buybacks don't change the principal value of a company’s shares. 

A dividend can take the form of a one-time special dividend or as an ongoing cash dividend to investors and owners. The form of these payments must be approved by the company’s shareholders.

Different types of dividends explained

Company dividends have been used since the 1600s, with the Dutch East India Company being the first public firm to pay dividends. Dividend payments can take many forms, with cash being the most common. The list below explains the forms of dividend payment.

Cash

These forms of dividends are normally paid out in currency, usually by cheque or electronic funds transfer, and they are usually taxable in the year that they are paid. This is the most usual way of sharing company profits with shareholders. 

Each share owned has a set declared amount of money allocated to it. For example, if a shareholder has 100 shares and the cash dividends are 25p  a share, the total that the stockholder will be paid is £25. These dividends are not classed as an expense; they are however classed as a deduction of retained earnings.

Stock or scrip dividends

These are dividend stocks, paid in the form of additional stocks of the issuing company or another corporation (for example, a subsidiary). 

These dividend stocks are most commonly circulated in proportion to shares owned. Nothing will be gained if the dividend stocks are split – this is because the total amount of shares increases, but the value of each share is lowered, without changing the market capitalisation of the held shares.

Property dividends

This particular type of dividend is also known as dividends in specie and is paid out in assets. These types of dividends are actually quite rare and are mainly securities of other issuer owned companies.

Interim dividends

These are payments made before a company’s Annual General Meeting (AGM) and final financial statements. When declared, this dividend usually accompanies the company’s interim finances.

Other dividends

Financial assets with a known value can be shared as dividends (this includes warrants). For major corporations with subsidiaries, dividends can be put into shares of a subsidiary company.

Key dividend dates 

Declared dividends must be approved by the board of directors before they can be paid out. The list below is a brief run down of different types of dividend dates:

• Declaration date – these dividend dates are the days that the intention to pay dividends is declared by the board of directors. On this day, a liability is created and recorded on the company’s books. Once that is done, that company officially owes money to its stockholders.

• Ex-dividend dates – the day where share dividends are bought and sold and are no longer to be paid. In the US, this is normally two days before the record date.

• Book closure date – this dividend date is when a company declares a dividend. It will also issue a date where the company will temporarily close its books for a fresh feed of stocks.

• In-dividend dates – this is one trading day before the ex-dividend date, where existing shareholders and any buyers of stock on this day will receive dividends and any holders who are selling their stock lose the right to their dividends.

• Payment date – the day where the dividends are transferred to the shareholders’ bank accounts or the cheques are mailed out to them.

• Record date – registered shareholders on company files will be paid their dividends on this date. Shareholders who are not registered by this day will not receive payment.

What do dividends mean in trading and investing?

There are many reasons why dividends are thought to be positive, the main one being the “Bird in Hand” argument regarding dividend policy. 

This states that investors are more wary of receiving any capital gains or future growth from retained earnings than they are of receiving current dividend payments. This is due to the idea that investors hold the value of the current dollar they would be certain to receive as higher than that of the reinvested dollar they are expected to receive.

Certain countries treat the money made from dividends at a more positive tax rate than everyday income. Investors wanting tax advantages capital may seek dividend paying stock as a way of reaping the benefits of potentially positive taxation.

Meanwhile, if a company has a long and favourable history of past dividends payment, the reduction or complete elimination of payable dividends may suggest to an investor that the company is struggling. In contrast, an increase in dividend rate may suggest a positive shift.

Major established companies tend to offer more dividend stocks as they have an interest in maintaining and growing shareholder wealth in ways other than normal share price growth. On the other hand, start-ups and high-growth companies in the fields such as technology and biotechnology very rarely offer dividends, as their profits are usually reinvested to help maintain a higher than average level of growth.

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