Dividends are a portion of company earnings regularly paid to shareholders, paid as some fixed amount per share price.
Describe the process of issuing a dividend
- Dividends are periodical payments a corporation can choose to issue to its shareholders, with the amount of payment to each shareholder commensurate with their number of shares. They may be paid as cash, additional stock, or property.
- Dividends may also be categorized as common stock or preferred dividends; preferred stock owners get their dividends paid in full first, before any common stock dividends are distributed.
- Ratios using dividend value, such as dividends per share (DPS), dividend yield, and payout ratio have historically been used as indicators of a stock’s investment strength and the company’s overall performance, though their usefulness has been contested.
- dividend: A pro rata payment of money by a company to its shareholders, usually made periodically (e.g., quarterly or annually).
- dividend yield: A company’s total annual dividend payment per share, divided by its price per share.
- dividends per share: The amount shareholders earn per share.
Dividends are payments made by a corporation to its shareholder members on a regular (usually quarterly) basis–these are essentially the shareholder’s portion of a company’s profits. A dividend is allocated as a fixed amount per share. Therefore, a shareholder receives a dividend in proportion to their shareholding; owning more shares results in greater dividends for the shareholder. When it is time to make dividend payments, corporations always pay preferred stock owners first, and then common stock dividends are allocated after all preferred dividends are paid in full. In the United States, dividends are usually declared quarterly by the corporation’s board of directors.
Dividends per share (DPS) refers to the dollar amount shareholders earn for each share, calculated by dividing total dividend amount by total number of shares outstanding. Dividend yield refers the ratio between dividends per share and the market price of each share, and it is expressed in terms of percentage. Payout ratio is calculated by dividing the company’s dividend by the earnings per share. A payout ratio greater than 1 means the company is paying out more in dividends for the year than it earned, while a low payout ratio indicates that the company is retaining a greater proportion of their earnings instead of paying out dividends. These ratios have historically been used as indicators of a stock’s investment strength and the company’s overall performance.
Dividends may be allocated in different forms of payment, outlined below: Cash dividends are the most common. As the name suggests, these are paid out as currency via electronic funds transfer or a printed paper check. For each share owned, a declared amount of money is distributed. Thus, if a person owns 1000 shares and the cash dividend is USD 0.90 per share, the holder of the stock will be paid USD 900.Stock dividends (also known as scrips) are payments in the form of additional stock shares of the company itself or one of its subsidiaries, as the name suggests. This may be a more palatable option for companies who would prefer to use its earnings towards growth of the company, rather than diverting them into cash dividends for shareholders. Property dividends or dividends in specie (Latin for “in kind”) are those paid out in the form of assets from the issuing corporation or another corporation, such as a subsidiary corporation. They are relatively rare and can take the form of securities of other companies owned by the issuer, or products and services. Companies may also offer reinvestment plans where shareholders can automatically reinvest dividends into more stock.
For public companies, there are six important dates to remember regarding dividends:
- Declaration date is the day the board of directors announces its intention to pay a dividend. On this day, a liability is created and the company records that liability on its books; it now owes the money to the stockholders. The board will also announce a date of record and a payment date.
- In-dividend date is the last day, which is one trading day before the ex-dividend date, where the stock is said to be cum dividend (‘with [including] dividend’). In other words, existing holders of the stock and anyone who buys it on this day will receive the dividend, whereas any holders selling the stock lose their right to the dividend. After this date the stock becomes ex-dividend.
- Ex-dividend date (typically two trading days before the record date for U.S. securities) is the day on which all shares bought and sold no longer come attached with the right to be paid the most recently declared dividend. This is an important date for any company that has many stockholders, including those that trade on exchanges, as it makes reconciliation of who is to be paid the dividend easier. Existing holders of the stock will receive the dividend even if they now sell the stock, whereas anyone who now buys the stock will not receive the dividend. It is relatively common for a stock’s price to decrease on the ex-dividend date by an amount roughly equal to the dividend paid. This reflects the decrease in the company’s assets resulting from the declaration of the dividend. The company does not take any explicit action to adjust its stock price; in an efficient market, buyers and sellers will automatically price this in.
- Book closure date is when company will ideally temporarily close its books for fresh transfers of stock.
- Record date refers to the date that shareholders must be registered on record in order to receive the dividend. Shareholders who are not registered as of this date will not receive the dividend.
- Payment date is the day when the dividends will actually be distributed to the shareholders of a company or credited to brokerage accounts.
The Nature of Dividends
Dividends are attractive to many investors because they are seen as steady streams of income from low risk investments.
Analyze what dividends mean to an investor making a decision on which stock to include in her portfolio
- Dividends offer consistent returns on relatively low risk investments. While companies experiencing rapid growth are unlikely to offer dividends, established companies with stable business and less room to grow do pay dividends to shareholders.
- A firm’s dividend decision may also serve as a signalling device about a firm’s future prospects. Due to information asymmetry between investors and the firm managers, investors will look to indicators like dividend decisions, which may give clues about what the firm managers forecast for the firm.
- Critics of dividends contend that company profits are better used reinvested back into the company for research, development, and capital expansion.
- information asymmetry: In economics and contract theory, information asymmetry deals with the study of decisions in transactions where one party has more or better information than the other.
The nature of dividends may appeal to investors because they offer consistent returns on relatively low risk investments. While companies experiencing rapid growth are unlikely to offer dividends, established companies with stable business and less room to grow do pay dividends to shareholders. Despite the low earnings growth of these stocks, shareholders get the benefit of knowing that the value of their initial investment is likely to remain stable. They can still profit off a steady stream of dividend payments.
A firm’s dividend decision may also serve as a signaling device which gives clues about a firm’s future prospects. Due to information asymmetry between investors and the firm managers, investors will look to indicators like dividend decisions. Studies have shown that stock prices tend to increase when an increase in dividends is announced and tend to decrease when a decrease or omission is announced. Managers have more information than investors about the firm, and such information may inform their dividend decisions. When managers lack confidence in the firm’s ability to generate cash flows in the future they may keep dividends constant or possibly even reduce the amount of dividends paid out. Conversely, managers that have access to information that indicates very good future prospects for the firm are more likely to increase dividends.
Investors can use this knowledge about managers’ behavior to determine their decision to buy or sell the firm’s stock, bidding the price up in the case of a positive dividend surprise or selling it down when dividends do not meet expectations. This, in turn, may influence the dividend decision as managers know that stock holders closely watch dividend announcements looking for good or bad news. Managers tend to avoid sending a negative signal to the market about the future prospects of their firm. This also tends to lead to a dividend policy of a steady, gradually increasing payment.
On the other hand, critics of dividends contend that company profits are best re-invested back into the company for research and development, capital expansion, and so forth. Their view is that an eagerness to return profits to shareholders may signal to investors that the management does not have ideas for the firm’s future prospects.
Dividend Irrelevance Theory
Under perfect market conditions, stockholders would ultimately be indifferent between returns from dividends or returns from capital gains.
Discuss the implications and assumptions of the Modigliani-Miller theory
- Dividend irrelevance comes from Modigliani-Miller’s capital irrelevance model, which works under specific market conditions–no taxes, no transaction costs, and no flotation costs. Investors and firms must have identical borrowing and lending rates and the same information on the firm’s prospects.
- Firms that pay more dividends offer less stock price appreciation. However, the total return from both dividends and capital gains to stockholders should be the same, so stockholders would ultimately be indifferent between the two choices.
- If dividends are too small, a stockholder can simply choose to sell some portion of their stock for cash and vice versa.
- flotation costs: Costs paid by a firm for the issuance of new stocks or bonds.
- dividend irrelevance: Theory that a firm’s dividend policy is not relevant because stockholders are ultimately indifferent between receiving returns from dividends or capital gain.
- capital gains: Profit that results from a disposition of a capital asset, such as stock, bond, or real estate due to arbitrage.
Economists Modigliani and Miller put forth a theory that only the firm’s ability to earn money and riskiness of its activity can have an impact on the value of the company; the value of a firm is unaffected by how that firm is financed. It does not matter if the firm’s capital is raised by issuing stock or selling debt, nor does it matter what the firm’s dividend policy is. Dividend irrelevance follows from this capital structure irrelevance.
Modigliani-Miller grounded their theory on a set of assumptions:
- No time lag and transaction costs exist.
- Securities can be split into any parts (i.e., they are divisible).
- No taxes and flotation costs.
- Financial leverage does not affect the cost of capital.
- Both managers and investors have access to the same information.
- Firm’s cost of equity is not affected in any way by distribution of income between dividend and retained earnings.
- Dividend policy has no impact on firm’s capital budget
Under these frictionless perfect capital market assumptions, dividend irrelevance follows from the Modigliani-Miller theorem. Essentially, firms that pay more dividends offer less stock price appreciation that would benefit stock owners who could choose to profit from selling the stock. However, the total return from both dividends and capital gains to stockholders should be the same. If dividends are too small, a stockholder can simply choose to sell some portion of his stock. Therefore, if there are no tax advantages or disadvantages involved with these two options, stockholders would ultimately be indifferent between returns from dividends or returns from capital gains.
Since the publication of the papers by Modigliani and Miller, numerous studies have shown that it does not make any difference to the wealth of shareholders whether a company has a high dividend yield or if a company uses its earnings to reinvest in the company and achieves higher growth. However, the importance of a firm’s dividend decision is still contested, with a number of theories arguing for dividend relevance.
Value of a Low Dividend
Low dividend payouts can be interpreted in a number of ways, including: as a leading indicator of future growth or a sign of instability.
Discuss the advantages of a stock having a low dividend
- A relatively low payout could mean that the company is retaining more earnings toward developing the firm instead of paying stockholders, which hints at future growth. Future capital gains also have tax advantages. These are all factors in favor of investing in stocks with low dividends.
- If a stock has a low dividend yield, this implies that the stock’s market price is considerably higher than the dividend payments a shareholder gets from owning the stock. This may indicate an overvalued stock or larger dividends in the future.
- A history of low or falling yields may indicate that the firm’s cash situation is not stable. They cannot afford to give higher dividends because they do lack cash on hand. As a result, there is some measure of risk involved with these low dividend investments.
- dividend yield: A company’s total annual dividend payment per share, divided by its price per share.
- dividend cover: The ratio of total earnings to total dividend payments.
The value of a dividend is expressed as some percentage proportion of the number of shares held. A relatively low payout could mean that the company is retaining more earnings toward developing the firm instead of paying stockholders. Some investors would prefer this low payout because it hints at future growth. Furthermore, retained earnings lead to long-term capital gains, which have taxation advantages over high dividend payouts, according to the Taxation Preference Theory. Taxes on capital gains are deferred into the future when the stock is actually sold, as opposed to immediately like cash dividends. Furthermore, capital gains are taxed at lower rates than dividends. Therefore, taxation benefit is another point in favor of low dividend payouts.
However, under dividend irrelevance theory, the actual value of a dividend is inconsequential to investors. If the dividend is too low, they can simply sell off part of their portfolio to generate more income for themselves. The conflicting theories on dividend policy complicate interpretations of low dividends in real life.
Dividend value must also be considered in relation to other measures of the firm, such as their earnings and stock price.
If a stock has a low dividend yield, this implies that the stock’s market price is considerably higher than the dividend payments a shareholder gets from owning the stock. There are a number of ways to interpret this ratio. A history of low or falling yields may indicate that the firm’s cash situation is not stable. They cannot afford to give higher dividends because they do lack cash on hand.
This instability can be seen in calculating the dividend cover, which is calculated as DC = EPS/DPS. A ratio of 2 or higher is considered safe—in the sense that the company can well afford the dividend—but anything below 1.5 is risky. If the ratio is under 1, the company is using its retained earnings from a previous year to pay this year’s dividend, which signals the risk of instability and poor performance of the firm. Signs of risk will deter investors, particularly if they are looking for cash dividends as a steady source of income.
Conversely, a low dividend yield can be considered evidence that the firm is experiencing rapid growth or that future dividends might be higher. Investors who prefer a “growth investment” strategy may prefer a stock with low to no dividend yields, as that is one of several indicators for a firm experiencing quick growth.
Value of a High Dividend
High dividend yields are attractive to investors who desire current income and stability since established firms often offer such stocks.
Discuss the advantages of owning stock that has a high dividend
- A high- yield stock is generally considered as a stock whose dividend yield is higher than the yield of any benchmark average such as the 10 year U.S. Treasury note, although the exact classification of high yield may differ depending on the analyst.
- High-yield may indicate undervaluation of the stock because the dividend is high relative to stock price or it can be a sign of a risky investment. If the high yield is due to a declining stock price, that reflects poorly on the firm’s performance and suggests that the dividend is unsustainable.
- Generally speaking, firms that usually pay out high dividends are quite mature, profitable, and stable. They pay out high dividends simply because they have too much cash flow and few positive net present value investment possibilities.
- The Dogs of the Dow strategy is a famous and extreme strategy using high dividend yields, where the investor buys the 10 highest dividend yielding stocks from the Dow Jones Industrial Average.
- Dogs of the Dow: An extreme investing strategy that dictates buying the 10 stocks with the highest dividend yields from the Dow Jones Industrial Average at the beginning of the year.
A high-yield stock is generally considered as a stock whose dividend yield is higher than the yield of any benchmark average such as the 10 year U.S. Treasury note. The classification of a high-yield stock is relative to the criteria of any given analyst. Some analysts may consider a 2% dividend yield to be high, while others may consider 2% to be low. There is no set standard for judging whether a dividend yield is high or low. A high dividend yield indicates undervaluation of the stock because the stock’s dividend is high relative to the stock price. High dividend yields are particularly sought after by income and value investors. High-yield stocks tend to outperform low yield and no yield stocks during bear markets because many investors consider dividend paying stocks to be less risky.
Generally speaking, most firms that pay out high dividends are quite mature, profitable, and stable. They pay out high dividends simply because they have too much cash flow and few positive net present value investment possibilities. But not all firms offering high dividend yields are steady, reliable investments. Perhaps the greatest risk in high-dividend securities is a falling stock price, which means that the high yield is due to decline of the firm. If a company is not earning enough profit to cover their dividend payments, the current dividend is unsustainable. In this case, a falling stock price indicates investor fears of a dividend cut. Therefore, if an investor buys these risky high-dividend stocks and the dividend is decreased because the company is suffering losses, the investor will have the problem of both less dividend income and portfolio of stocks with declining values. There may be investors, such as retirees, who prefer current income from high dividends to low dividends and growth in stock value. Theories may say this should not matter since investors could sell a portion of the low dividend paying stocks to supplement cash flow, but in the real world, markets are not frictionless. The sale of securities involves transaction costs that may outweigh any benefits of the sale. Therefore, some individuals are better off holding high dividend stock.
The Dogs of the Dow strategy is a well known and rather extreme strategy that incorporates high dividend yields. The strategy dictates that the investor compile a list of the 10 highest dividend yielding stocks from the Dow Jones Industrial Average and buying an equal position in all 10 at the beginning of each year. At the end of each year, the investor finds the 10 highest dividend yield stocks again, and reallocates their positions so as to have an equal position in all 10 Dogs of the Dow. The Dogs of the Dow made a compounded annual return of 18% from 1975 to 1999 outperforming the market by 3%. This would make 10,000 turn into 625,000 in 25 years.
Proponents of the Dogs of the Dow strategy argue that blue chip companies do not alter their dividend to reflect trading conditions. Therefore, the dividend is a measure of the average worth of the company. In contrast, the stock price fluctuates through the business cycle. This should mean that companies with a high yield, with high dividend relative to price, are near the bottom of their business cycle and are likely to see their stock price increase faster than low yield companies. Under this model, an investor annually reinvesting in high-yield companies should out-perform the overall market. The logic behind this is that a high dividend yield suggests both that the stock is oversold and that management believes in its company’s prospects and is willing to back that up by paying out a relatively high dividend. Investors are thereby hoping to benefit from both above average stock price gains as well as a relatively high quarterly dividend. Of course, several assumptions are made in this argument. The first assumption is that the dividend price reflects the company size rather than the company business model. The second is that companies have a natural, repeating cycle in which good performances are predicted by bad ones.