What are Dividends?In Finance Management, dividends are a portion of the company's profits paid out to its shareholders. When a company earns a profit, there are two ways in which it can utilize the surplus funds. The company can either decide to reinvest the profits in the business (retained earnings) or distribute it to it's shareholders. The distribution of cash to the shareholders takes two forms: one is share repurchase, and the other is dividends.
In most companies, a part of the profit is kept as retained earnings and the remaining is distributed to the shareholders.
Here are a few salient features of dividends:
- The dividends are generally paid based on a payout policy of the company.
- The board of directors of the company declares the dividends every year. In some jurisdictions, such as UK, these board actions require the approval of the shareholders. However, in other jurisdictions such as US, such approval may not be required.
- Dividends are generally paid as a fixed amount per share. For example, $1 per share. Therefore, the shareholders will receive the dividends based on their holdings.
- Unlike, the payment of interest and principal of corporate bet, the payment of dividends to common shareholders is not mandatory, as based on the company’s performance; the company may decide not to pay dividends in a particular year.
- Payment of dividend is not considered an expense, rather is paid to shareholders from the after-tax profits. In some jurisdictions, the dividends may be taxed at the shareholder level. The tax treatment of dividends may also differ from capital gains tax.
- The dividends can be paid in many forms such as cash dividends, extra dividends, stock dividends, stock splits, and reverse stock splits.
Types of DividendsA company can pay dividends in many different forms. The most common form of dividend payment is cash dividends. Let’s take a look at the different forms of dividends:
Cash Dividends: A company may decide to pay dividends in the form of cash based on a schedule. Cash dividends can be regular dividends, special dividends, or liquidating dividends.
Stock Dividends: In this case, the company pays dividends as new stocks, rather than cash.
Stock Splits: In this case, the company decides to split each share into multiple shares. A 2-for-1 stock split
means each old stock is split into two new stocks.
Reverse Stock Splits: Reverse stock splits work exactly opposite to stock splits. Instead of splitting shares, multiple shares are combined into fewer shares. For example a 1-for-2 reverse stock split means 1 new share is issued for every two old shares.
Each of these types of dividend methods has different impact of the shareholder value and the company. These dividends also impact the financial ratios of the firm.
Cash DividendA company may decide to pay dividends in the form of cash based on a schedule. The frequency of payments for cash dividends varies across countries. For example, in the US and Canada, the dividends are usually paid quarterly, in Europe, they are paid semi-annually, while in most Asian countries, it is paid annually.
Cash dividends can be in the form of regular dividends, special dividends or liquidating dividends.
- Regular Dividends: These are the dividends that the companies’ pay based on a regular schedule (quarterly, semi-annually, or yearly). It is important for companies to maintain a stable record as it is seen as a sign of financial stability. An increase in regular dividends is also seen as a positive sign that directly impacts the share price.
- Special Dividends: Special dividends are paid either by companies that don’t pay regular dividends or by companies that pay regular dividends in addition to their regular dividends as a one-time dividend. Such dividends are usually paid in special circumstances such as when a company has huge excess cash or makes phenomenal earnings in a particular period. These are also called irregular or extra dividends. Companies in cyclical industries generally adopt this form of dividends. They will pay less regular dividends but will announce special dividends in good times.
- Liquidating Dividends: When a company goes out of business and liquidates all its assets, it distributes the proceeds from liquidation to the shareholders in the form of liquidating dividends. Even when a company sells a portion of its assets and distributes the proceeds to shareholders, it’s known as liquidating dividends. In some cases, a company may also
Impact of Cash DividendsThe payment of cash dividends reduces company’s cash, and thus its assets. It also reduces the market value of the shares by the equivalent amount. Therefore, when a company pays cash dividends, the market value of its stock will drop. For example, if the current stock price is $20, and a dividend of $1 is paid, then the stock price immediately after dividend payment will be $19.
Impact on Financial RatiosThe decrease in cash and assets will have the following impact on financial ratios:
- Liquidity ratios will decrease
- Debt-to-asset ratio will increase
- Debt-to equity ratio will increase
Stock DividendsStock dividends are the dividends paid in the form of new stock rather than cash. This is also known as the bonus issue of shares. In general, companies pay 2-10% of stock dividends on the total shares outstanding.
When dividends are paid in this form, after the dividend payment there will be more shares outstanding, however, the value of each stock would have reduced.
For example, assume that a shareholder has 10 shares of $10 each. The total value of shares is $100. If the company pays 10% stock dividends (1 new stock), the shareholder will now have 11 shares valuing $100. The value of each stock will now be 9.09.
Here are a few important points about stock dividends:
- The total number of shares for each shareholder increases.
- The company does not have to spend any extra cash to issue dividends.
- Stock dividends are not taxable, because there is no change in shareholder value.
- Stock dividends don’t change the ownership structure.
- Stock dividends don’t affect the shareholder’s wealth but the price of each stock reduces.
- Stock dividends are very commonly used in China.
- Stock dividends do not affect liquidity or financial leverage ratios because they don’t affect the assets or equity.
Let’s take a simple example to understand the impact of 10% stock dividends on shareholder
As you can see, there is no change in ownership value or ownership stake after stock dividends.
Stock Splits and Reverse Stock SplitsA stock split refers to a situation where a company decides to split each share into multiple shares. A 3-for-1 stock split means each old stock is split into 3 new stocks. The impact is that the total outstanding shares increase, but the value of each share declines proportionately.
- Similar to stock dividends, stock splits have no impact on the total shareholder value or the shareholders’ wealth.
- Two-for-one and three-for-one are the most commonly used stock splits, although a company may decide any fraction.
- Companies generally go for stock splits in order to keep their stocks in a certain price range ($20 to $80 is preferred).
- Theoretically, the price of the stock will fall proportionately after the stock split. However, the academic research shows that the stock splits have a positive impact on the company and the actual stock price may be more than its theoretical value.
- Stock splits reduce market liquidity of stocks because the stock prices are now low which makes the percentage brokerage high.
Reverse stock splits are exactly the opposite of stock splits. In this case multiple shares are combined into fewer shares. Here also the key motive is to keep the stock prices within the optimal price band of $20 to $80. So, if a company’s stock price is below this level, the company may go for reverse stock split to increase the stock price.
Impact on Financial Ratios
Stock splits and reverse stock splits have no impact on liquidity ratios, financial leverage ratios, as there is no change in the company’s assets or equity.
Dividend Payment DatesOnce a company decides to pay the dividends, the process of dividend payment starts. The dividend payment chronology is quite standardized but may have some variations in different markets.
Here we will look at the common and important dates in the chronology:
Declaration date: This is the first date on timeline on which the company officially declares a dividend, be it a regular dividend or any other type of dividend. The company’s board authorizes the dividend payment and it is announced. On this date, the company will also announce the record date and the actual payment date for the dividend.
Ex-dividend date: Also called the ex-date, it is the date from which the stock starts trading without dividend. So, any investor who purchases the stock on or after the ex-date will do so at the post-dividend price. Any investor who owns the stock before this date will receive the dividends. In most global markets, the ex-dividend date is set two days before the record date. This is done to adjust for the settlement cycle, which is T+3. In markets like Hong Kong Stock Exchange, the ex-date is one day before the record date because they have T+2 settlement cycle.
Record date: Also called holder-of-record date, this is the date on which the shareholders with the ownership of the stock are designated to receive the dividend. This date is usually two days after the ex-dividend date. This date is determined by the company and is generally one week to one month after the declaration date.
Payment date: This is the date on which the dividend is actually paid out to the shareholders. This date is also decided by the company and can fall on any date including a public holiday. The time between the record date and payment date can vary from a few days to a month or more.
For cash dividends, most companies will usually have a set schedule for dividend payments.
What is dividend policy?
Once a company makes a profit, they must decide on what to do with those profits. They could continue to retain the profits within the company, or they could pay out the profits to the owners of the firm in the form of dividends. Once the company decides on whether to pay dividends, they may establish a somewhat permanent dividend policy, which may in turn impact on investors and perceptions of the company in the financial markets. What they decide depends on the situation of the company now and in the future. It also depends on the preferences of investors and potential investors.
Residual Dividend Policy: The term residual dividend refers to a method of calculating dividends. A dividend is a payment made by a company to its shareholders. It is essentially a portion of the company's profits that is divided amongst the people who own stock in the company. A residual dividend policy is one where a company uses residual or leftover equity to fund dividend payments. Typically, this method of dividend payment creates volatility in the dividend payments that may be undesirable for some investors.
Dividend Policy and Stock Value:
Dividend Irrelevance Theory: This theory purports that a firm's dividend policy has no effect on either its value or its cost of capital. Investors value dividends and capital gains equally.
Optimal Dividend Policy: Proponents believe that there is a dividend policy that strikes a balance between
current dividends and future growth that maximizes the firm's stock price.
Dividend Relevance Theory: The value of a firm is affected by its dividend policy. The optimal dividend policy is the one that maximizes the firm's value.
Various Dividend Models:
- Dividend Relevance Model
- Traditional Model
- Walter Model
- Gordon Model
- Dividend Irrelevance Model
- Miller & Modigliani Position
Traditional models: It is given by B Graham and DL Dodd. This model lays down a clear emphasis on the relationship between the dividends and the stock market. According to this model, the stock value responds positively to higher dividends and negatively when there are low dividends.
This model establishes the relationship between market price and dividends using a multiplier.
P/E ratios are directly related to the dividend payout ratios that is, a higher dividend payout ratio will increase the P/E ratio and vice-versa.
P = m (D+E/3)
In which; P = market price
M = multiplier
D = Dividend per share
E = Earnings per share
- P/E ratios are directly related to the dividend payout ratios is not true for a firm’s whose payout is low but its earnings are increasing.
- This approach does not hold good for those firm whose payout is high but have slow growth rate.
- There may be few investors who would prefer the dividends to the uncertain capital gains and a few who would prefer low taxed capital gains.
- These conflicting factors have not been properly explained by traditional approach.
Walter Model: The dividend policy given by James E Walter considers that dividends are relevant and they do affect the share price.In this model, he studied the relationship between the internal rate of return (r) and the cost of capital of the firm (K), to give a dividend policy that maximizes the shareholders’ wealth.
The model studies the relevance of the dividend policy in three situations;
r > Ke
r < Ke
r = Ke
According to Walter When r > Ke the firm has to adopt Zero% payout policy.
r < ke the firm has to adopt 100% payout policy.
r = ke any policy between 0 to 100% payout.
Dividend Yield: A financial ratio that shows how much a company pays out in dividends each year relative to its share price. In the absence of any capital gains, the dividend yield is the return on investment for a stock. Dividend yield is calculated as follows:
Dividend Yields=Annual Dividends per share/Price Per share.
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