A dividend, also known as distribution, is a portion of a company’s profits that the company may decide to distribute to its shareholders. Dividends are usually a percentage of a company’s earnings, which is called the dividend payout ratio.
To understand the concept of dividends, one must thoroughly understand the concept of shares. Purchasing a share in a particular company entitles ‘shareholders’ to ownership in the company and therefore entitles them to receive dividends. Click here to learn more about shares.
Whilst many companies, especially established companies with earnings, elect to pay dividends, a public company is not obligated to do so. It is often seen that large and established companies distribute dividends, while the smaller companies focus on retaining their earnings in order to grow their business. It is at the company’s discretion to either retain its profits for reinvestment purposes or distribute dividends to its shareholders as a reward. One of the most famous examples of companies that do not pay dividends is Alphabet Inc. (NASDAQ:GOOGL), the parent company of the search engine Google, which has to date (Feb-2016) not paid a single dividend to its shareholders.
The most common type of dividend used is the cash dividend whereby the company pays a certain amount of dividend in cash. However the company may also choose to pay a ‘stock dividend’ whereby it issues common shares to its shareholders without any consideration.
Most of the ASX listed companies distribute dividends twice a year, which are called the ‘interim’ and ‘final’ dividend. ‘Special’ dividends may also be distributed if the company posted exceptionally strong earnings and decides to reward shareholders.
Companies that distribute regular dividends over a long period of time, are often considered as ‘reliable’ or ‘stable’. It is often seen that a company’s stock price increases if the company pays dividends as it provides investors with a reason to buy. If companies have paid dividends in the past and decide to reduce or even stop paying dividends, they may experience a decline in the overall value of the company.
Some analysts believe that companies who do not pay dividends, but rather reinvest surplus cash into the business, will increase the value of the firm more rapidly. An alternative to paying dividends may also be firms deciding to repurchase their own stock, which reduces the amount of shares outstanding and results in buying pressure for the stock. In reality, companies often decide to do both.
Generally, every holder of a company’s security or common stock is entitled to receive a dividend. Preferred stockholders are entitled to fixed dividends for as long as the company remains profitable and generally receive dividends before common stockholders. Mutual funds and ETF shareholders may also be entitled to receive dividends, however it may vary depending on the conditions of the security.
Terminology: Dividend Dates, Dividend Yield, Franking Credits
1. Dividend dates: There are four important dates investors should be aware of:
a. Record Date: The date when the company determines which shareholders are eligible for the dividend payment.
b. Ex-dividend Date: in Australia the ex-dividend date usually occurs two business days before the record date. It is very important to note that an investor must have purchased the shares before the ex-dividend date in order to be eligible to receive the dividend. On the ex-dividend the stock price usually decreases by the amount of the dividend.
c. Cum dividend: This refers to the period before the ex-dividend date. Hence, if shares are bought during the cum dividend period, investors are entitled to receive the upcoming dividend.
d. Date Payable: This is the date on which the dividend is paid to shareholders.
2. Dividend Yield: The Dividend yield is the dividend expressed as a percentage of the current share price of a company. For example if the company’s stock is trading at $100 and the company distributes a dividend of $5, the dividend yield is 5% ($5/$100). Stock prices and net dividend payments are often not comparable as the value per share depends on the total amounts of shares outstanding, hence a percentage figure is a more accurate way of analysing the size of the dividend.
3. Franking credits: This is a type of tax credit, also known as imputation credit, that allows Australian companies to pass on tax benefits to its shareholders, as the company has already paid tax for its earnings. The credit can be used to reduce income tax paid on dividend.
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