Dividends

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. The annual dividend per share divided by the share price is the dividend yield.

Steps of how it works:

• The company generates profits and retained earnings
• The management team decides some excess profits should be paid out to shareholders (instead of being reinvested)
• The board approves the planned dividend
• The company announces the dividend (the value per share, the date when it will be paid, the record date, etc.)
• The dividend is paid to shareholders

Dividend vs buyback

Managers of corporations have several types of distributions they can make to the shareholders. The two most common types are dividends and share buybacks. A share buyback is when a company uses cash on the balance sheet to repurchase shares in the open market. This has two effects.

(1) It returns cash to shareholders

(2) It reduces the number of shares outstanding.

The reason to perform share buybacks as an alternative means of returning capital to shareholders is that it can help boost a company’s EPS. By reducing the number of shares outstanding, the denominator in EPS (net earnings/shares outstanding) is reduced and, thus, EPS increases.  Managers of corporations are frequently evaluated on their ability to grow earnings per share, so they may be incentivized to use this strategy.

Types of Dividend

A dividend is generally considered to be a cash payment issued to the holders of company stock. However, there are several types of dividends, some of which do not involve the payment of cash to shareholders. These dividend types are:

1. Cash Dividend

The cash dividend is by far the most common of the dividend types used. On the date of declaration, the board of directors resolves to pay a certain dividend amount in cash to those investors holding the company’s stock on a specific date. The date of record is the date on which dividends are assigned to the holders of the company’s stock. On the date of payment, the company issues dividend payments.

2. Stock Dividend

A stock dividend is the issuance by a company of its common stock to its common shareholders without any consideration. If the company issues less than 25 percent of the total number of previously outstanding shares, then treat the transaction as a stock dividend. If the transaction is for a greater proportion of the previously outstanding shares, then treat the transaction as a stock split.  To record a stock dividend, transfer from retained earnings to the capital stock and additional paid-in capital accounts an amount equal to the fair value of the additional shares issued. The fair value of the additional shares issued is based on their fair market value when the dividend is declared.

3. Property Dividend

A company may issue a non-monetary dividend to investors, rather than making a cash or stock payment. Record this distribution at the fair market value of the assets distributed. Since the fair market value is likely to vary somewhat from the book value of the assets, the company will likely record the variance as a gain or loss. This accounting rule can sometimes lead a business to deliberately issue property dividends in order to alter their taxable and/or reported income.

4. Scrip Dividend

A company may not have sufficient funds to issue dividends in the near future, so instead it issues a scrip dividend, which is essentially a promissory note (which may or may not include interest) to pay shareholders at a later date. This dividend creates a note payable.

5. Liquidating Dividend

When the board of directors wishes to return the capital originally contributed by shareholders as a dividend, it is called a liquidating dividend, and may be a precursor to shutting down the business.  The accounting for a liquidating dividend is similar to the entries for a cash dividend, except that the funds are considered to come from the additional paid-in capital account.

Significance of Dividend

Dividend policy is about the decision of the management regarding distribution of profits as dividends. This policy is probably the most important single area of decision making for finance manager. Action taken by the management in this area affects growth rate of the firm, its credit standing, share prices and ultimately the overall value of the firm.

Erroneous dividend policy may plunge the firm in financial predicament and capital structure of the firm may turn out unbalanced. Progress of the firm may be hamstrung owing to insufficiency of resources which may result in fall in earnings per share.

Stock market is very likely to react to this development and share prices may tend to sag leading to decline in total value of the firm. Extreme care and prudence on the part of the policy framers is, therefore, necessary.

If strict dividend policy is formulated to retain larger share of earnings, sufficiently larger resources would be available to the firm for its growth and modernization purposes. This will give rise to business earnings. In view of improved earning position and robust financial health of the enterprise, the value of shares will increase and a capital gain will result.

Thus, shareholders earn capital gain in lieu of dividend income; the former in the long run while the latter in the short run.

The reverse holds true if liberal dividend policy is followed to pay out high dividends to share-holders. As a result of this, the stockholders’ dividend earnings will increase but possibility of earning capital gains is reduced.

Significance:

Dividends are a reliable income source

To begin with, it is important to realize the positioning of dividends in your investment portfolio and income sources. It is important to note that dividends are a stable and reliable income that investors receive without making any alterations to their investment portfolio.

Generally, a major income flows in only when you sell off your shares or stocks. But, with dividends you get an income source that comes without any variance to your portfolio. Although the companies are under no obligation to pay out dividends to investors, major companies who have been flourishing in the markets over the years do maintain a regular dividend sharing practice with their shareholders.

Dividends are tax-efficient

Investors can save a major chunk of their earnings from high taxes by opting for dividend options. Being a steady income source, dividends are taxed differently if managed well. The tax rates for qualified dividends range between 5% and 15%, depending upon the income range. Typically, a low-income range is taxed at a rate of 5% which is quite low as compared to the percentage of tax charged on other investments which is generally above 25%. There is several tax advantages associated with your dividend earnings unlike income from other investments.

Dividends are a good growth opportunity

When you invest in dividend paying companies, you are essentially expanding your return horizons. Most of the well-established companies or market players not only stay consistent with dividend payouts to their investors but also increase the dividend percentage at regular intervals (generally once every year). Although, risk cannot completely be eliminated while investing in market-related instruments, investing in dividend paying companies can assure partial returns over investments that can be better than non-profiting investments in stocks, especially in such volatile markets.

Of course, there are exceptions, but only a few dividend paying companies have faltered over the years. The rest of them have been consistent in paying out dividends with a promising future ahead.

Dividends allow portfolio expansion

With dividends acting as a steady side income source, investors have an excellent opportunity to expand and diversify their investment portfolio. Portfolio diversification is essential to your financial health requiring a considerable income at disposal to be invested across industries. Even if you invest the SIP way, you will still require regular money. Dividends, on the other hand, allow investors a higher level of flexibility that helps them make good investment decisions while expanding their portfolio.

Also, when you reinvest your dividends, you are creating more sources of income by acquiring more shares. You can always manage the flow of money as per your requirements since there is a provision to reinvest a partial percentage of your dividend earnings back to the investments. Moreover, investors are allowed to make a free reinvestment of their dividend earnings back to the original source.

Dividends help beat inflation

Inflation can be a hole in the pocket with the capability to eat away all your hard-earned money. While budgeting or evaluating the profit earnings, investors generally forget to factor-in inflation that later on challenges their foundational assumptions and estimates.

Dividends help investors to balance out the loss caused by inflation in order to reap any actual benefit from their investments. For instance, if you earn an average profit of 7% per year on your investments and inflation for the given year is 8%, then realistically you have incurred a loss of 1% rather than any profit. This in turn adversely affects the purchasing power of the capital.

On the other hand, if your investments offer a 7% return on investment plus a 4% dividend payout, then you have made a profit beating the rise in inflation. As a general rule, most dividend paying investments outrun the inflation affects, leaving the investor with a handful of earnings.

Dividends help manage risk and volatility

This might come as a surprise but dividends are quite handy when it comes to managing portfolio risk and volatility. When investors suffer losses due to a fall in the stock price, dividends help balance out the loss and mitigate the risk. There have been a lot of studies indicating a better performance on the part of dividend paying companies and stocks than the non-dividend paying ones. These trends have particularly stood out during the bearish cycles of the market. Even though a bear market is generally unfavourable to all industries and investment instruments, yet dividend paying stocks have outperformed their counterparts fairly well in those times as well.

The fact has been testified during the 2002 market fiasco when the overall downturn dragged the whole economy and investment industry into a considerable low. An average 30% downfall was observed in the overall market but to everyone’s surprise, the dividend paying stocks suffered only a 10% decline reinforcing the investors’ faith in them.

Dividends are sustainable

A person’s needs and wants grow every single day, leaving very little room for a balanced lifestyle and continual investing. Dividends act as the support system in such times promoting sustainability in income flow. With the diverse effects of inflation on the individual and the economy, one of the most reliable go-to options for a secured income is a dividend paying stock.