What are dividends? A complete guide

What are Dividends?

Dividends are an important part of investing and a key way for companies to reward shareholders.

Dividends represent a portion of a company’s profits that are distributed to shareholders, usually on a quarterly basis. When a company earns a profit, the board of directors can choose to either reinvest some or all of the profits back into the business or distribute a portion to shareholders in the form of dividends. Companies that consistently pay dividends often tend to be mature, stable, cash-generating businesses.

Common shareholders of dividend paying companies are entitled to receive a distribution as long as they own the stock before the ex-dividend date.

The amount and frequency of dividend payments can provide insight into the financial health and management strategy of a company. While dividends can provide a steady income stream for shareholders, there are some key risks and drawbacks to be aware of. Importantly, dividends are never guaranteed and can be cut or suspended at any time if a company is facing financial difficulty.

Types of Dividends

Dividends come in various forms, each with its unique characteristics. Broadly classified into cash dividends, stock dividends, and special dividends, these disbursements represent a company’s way of sharing profits with its investors. Within these primary categories, there are further distinctions, such as script dividends, property dividends, and liquidating dividends, each offering shareholders different ways to benefit from the company’s success.

Cash Dividends

Cash dividends, sometimes called common dividends, represent a tangible return on investment for shareholders, as companies distribute a portion of their profits directly in the form of cash. This financial reward is typically paid out regularly, often quarterly or annually, to investors holding shares in the company. When a company declares a cash dividend, shareholders receive a specific amount of money for each share they own. This payment provides shareholders with a direct and immediate benefit, allowing them to either pocket the funds or reinvest them as they see fit. Cash dividends serve as a means for companies to share their financial success with investors, fostering a mutually beneficial relationship between businesses and their shareholders.

We will take an in-depth look at ↓ cash dividends ↓ further down in this guide, as they are the most common and relevant type of dividend for most individual investors.

Stock Dividends

Stock dividends offer shareholders a unique form of participation in a company’s prosperity by distributing additional shares instead of cash. When a company declares a stock dividend, existing shareholders receive extra shares in proportion to their current holdings. This means that if you own a certain number of shares, you’ll be granted a percentage increase in your total share count. While stock dividends don’t provide an immediate cash benefit, they enhance shareholders’ ownership in the company. Essentially, it’s like receiving more slices of the same-sized pie. The overall value of the investment remains the same, but stock dividends provide an opportunity for shareholders to benefit from the company’s growth in the long term.

Special Dividends

Special dividends are like unexpected bonuses for shareholders, representing one-time payments that companies make outside of their regular dividend schedules. These dividends are typically declared when a company sees exceptional financial success, sells assets or a subsidiary, or undergoes a significant event that results in additional profits. Unlike regular dividends, special dividends aren’t part of the usual distribution plan and are therefore considered special bonuses for shareholders. These payments are a way for companies to share additional gains with their investors and can be a pleasant surprise, providing shareholders with an extra boost to their returns. Special dividends demonstrate a company’s intention to acknowledge and reward shareholders during particularly favourable circumstances.

Property Dividends

Property dividends present a unique way for companies to distribute value to shareholders, deviating from the more common cash and stock options. Instead of offering monetary or stock-based rewards, a company opting for property dividends distributes physical assets, bonds, or other securities to its shareholders. This form of dividend allows investors to directly receive a share of the company’s tangible assets. While less common than cash or stock dividends, property dividends provide shareholders with an alternative means of benefiting from a company’s success. It’s a distinctive way for companies to share value with their investors by directly providing ownership in specific assets rather than financial instruments.

Script Dividends

Script dividends, also known as dividend reinvestment plans (DRIPs), offer shareholders an alternative to receiving cash dividends. With script dividends, shareholders can choose to receive additional shares in the company instead of cash. This means that the dividend amount is used to purchase more shares at the current market price. Opting for script dividends allows shareholders to reinvest their earnings back into the company, potentially increasing the overall value of their investment over time. It provides a way for investors to compound their holdings without the need for additional capital. Script dividends cater to shareholders who prefer to reinvest in the company’s growth rather than receiving cash payouts.

Liquidating Dividends

Liquidating dividends mark a unique situation where a company distributes assets to its shareholders as part of the process of winding down its operations or selling off a significant portion of its business. In essence, these dividends are a final distribution of the company’s remaining assets to its shareholders before it concludes its business activities. Liquidating dividends can occur when a company is undergoing restructuring, liquidation, or significant changes in its business structure. Shareholders receive a portion of the company’s remaining assets, representing a conclusion to their investment as the company moves towards closure or a major transformation. While less common, liquidating dividends serves as a way for shareholders to partake in the remaining value of the company during its final stages.

How Often Are Dividends Paid?

Dividend payments tend to be made on a quarterly basis by most companies to their shareholders. However, there is no hard and fast rule dictating the frequency of these payouts. The board of directors makes the decision regarding dividend amounts and timing based on the company’s profits and objectives.

Once a business starts generating profits, it has several options on how to use that money. It can reinvest into the company, keep a reserve for emergency costs, buy back shares from shareholders, or distribute dividends. Carefully monitoring the dividend yield, declaration, ex-dividend and payment dates will help determine when and how much dividend you can expect.

Understanding Cash Dividends

Cash dividends are the most common form of dividends – and likely the only type of dividend most investors will deal with. Cash dividends represent a crucial part of a company’s financial strategy, providing a direct monetary return to its shareholders. These dividends are a way for companies to share their profits, demonstrating a commitment to rewarding investors for their trust and investment in the company.

The declaration of cash dividends has significant implications for both the company and its investors. On the positive side, it can enhance investor confidence and attract income-seeking investors who value a regular stream of returns. However, the decision to distribute cash dividends involves a careful balancing act. Whilst it can boost shareholder confidence, it also means allocating financial resources that could otherwise be reinvested in the company for future growth or used for other strategic initiatives.

The stock market’s reaction to cash dividends is a nuanced process. Initially, it may lead to a decline in overall share prices due to the outflow of funds. However, companies with a strong history of paying dividends may experience more stable or even rising share prices, as investors perceive consistent returns as a positive signal.

The decision to declare cash dividends requires a forward-looking approach, considering the firm’s future positioning and industry expectations. Capital requirements and investor preferences vary across industries, influencing how companies approach their dividend policies. Striking the right balance between rewarding shareholders and retaining funds for future initiatives is a strategic challenge that companies navigate.

To gauge the effectiveness of cash dividends, it is common for investors and analysts to compare dividend-related metrics, such as dividend yield and payout ratios, amongst similar companies or industries. This comparative analysis provides valuable insights into a company’s dividend policy within its specific business context.

Formula for Cash Dividends

The total amount set for dividends is divided by the total number of outstanding shares. This gives the “dividend per share,” which is the cash amount or additional shares each shareholder will receive for every share they own.

Calculating cash dividends is a straightforward process for companies. They use a simple formula: Cash dividend equals the dividend per share multiplied by the number of shares held by the shareholder.

Example

Let’s say a company declares a cash dividend of £1 per share, and you own 100 shares. Here’s how you calculate it:

Cash Dividend=£1×100=£100

So, as a shareholder with 100 shares, you would receive £100 in cash dividends. It’s like getting £1 for each share you own.

Per-Share Basis Clarification

Companies declare dividends on a per-share basis. This means that for each share an investor owns, they are entitled to a portion of the declared dividend. It’s a straightforward way to ensure fairness and simplicity in distributing profits to shareholders.

Dividend Payment Chronology

Understanding the timeline of cash dividends is essential as it outlines the key events and dates associated with receiving this financial reward. Let’s walk through the chronological steps:

• Declaration Date: The process begins with the company’s official announcement of its intention to pay dividends. During this declaration, the company specifies the amount of the dividend per share, providing shareholders with insight into the upcoming distribution.
• Holder of Record Date: This date establishes the list of shareholders eligible to receive the declared dividend. If you own shares on or before this date, you’re in line to receive the dividend. It’s a snapshot date determining who qualifies.
• Ex-Dividend Date: The ex-dividend date is significant for investors looking to buy shares and still receive the dividend. If you purchase shares on or after this date, you won’t be eligible for the upcoming dividend. This date usually precedes the holder of the record date.
• Cum Dividend Date: This is the last day on which buying shares ensures you’re entitled to the dividend. It’s a counterpart to the ex-dividend date. If you buy shares before this date, you’re considered “cum-dividend,” meaning you’re entitled to the dividend.
• Payment Date: The culmination of the process occurs on the payment date when the company distributes the cash dividends to eligible shareholders. This is the day investors see the tangible returns on their investment.

Example

Let’s consider a scenario involving Dave, a shareholder in Exchange Alley Ltd, a UK-based company. Dave owns 200 shares in Exchange Alley Ltd, which he purchased at £10 per share, amounting to a total investment of £2,000.

Cash Dividend Declaration:
Suppose Exchange Alley Ltd announces a cash dividend of £0.75 per share. Dave would then receive a total cash dividend of £150 (£0.75 * 200 shares).

Yield Calculation:
To calculate the yield on his investment:
Yield = Total Dividend / Cost of the Stock = £150 / £2,000 = 7.5%

Understanding the Dates:

• Declaration Date
  Exchange Alley Ltd declares a cash dividend on April 10.
• Holder of Record Date
  Shareholders on record by April 30 are eligible for the dividend.
• Ex-Dividend Date
  April 28 (new shareholders after this date are not eligible for the dividend).
• Trading Period
  From April 10 to April 27, shares are traded cum-dividend.
• Payment Date
  May 15, when the cash dividend is distributed to eligible shareholders.

Impact on Share Prices

Cash dividends can influence share prices. If the stock was trading at £12 before the event and falls to £11.50 afterwards, Dave’s shares would be impacted:

• Market value before the event: £12 * 200 shares = £2,400.
• Market value after the event: £11.50 * 200 shares = £2,300.

Considering the cash dividend received was £150, the total value after the event would be £2,450 (£2,300 + £150). This illustrates how the share value decreases by approximately the same amount as the cash dividend, demonstrating the impact of dividend distribution on stock prices.

Limitations

Limitations that investors and companies need to consider.

• Impact on Company Resources: Distributing cash dividends reduces the company’s cash reserves. This can limit the funds available for crucial operational needs, future investments, or strategic initiatives.
• Market Expectations: Companies establishing a pattern of regular cash dividends may face market expectations to maintain or increase dividend payments. Failing to meet these expectations can result in negative reactions from investors.
• Share Price Adjustments: The declaration of cash dividends often leads to a reduction in the company’s share price. This is because the market adjusts for the cash being distributed, impacting the overall valuation.
• Tax Implications: While shareholders receive cash dividends, they are also subject to taxation. Depending on the tax jurisdiction, dividend income may be taxed at different rates, affecting the net returns for investors.
• Preference for Growth: Some investors, particularly those seeking long-term growth, may prefer companies that reinvest profits into the business for expansion or innovation rather than distributing cash dividends.
• Market Conditions: Economic downturns or challenging market conditions may prompt companies to reduce or suspend cash dividend payments to conserve cash. This can impact income-oriented investors who rely on dividends for regular returns.
• Debt and Dividend Payments: Companies with significant debt obligations may need to allocate a portion of their profits to debt repayment rather than distributing cash dividends. This can impact the dividend amount or consistency.
• Equity Dilution: If a company issues additional shares to fund its operations, existing shareholders may experience equity dilution, reducing their proportional ownership and potentially impacting the per-share dividend amount.
• Changing Investor Preferences: Investor preferences may shift over time, with some favouring share buybacks or other forms of return on investment over traditional cash dividends.
• Legal Restrictions: Companies may face legal restrictions on the payment of cash dividends, such as covenants in loan agreements or regulatory constraints. These restrictions can impact the flexibility of dividend declarations.

Cash Dividend vs Stock Dividend

Both cash dividends and stock dividends are methods used by companies to distribute profits to shareholders. However, key differences exist between the two:

Cash Dividend

The essence of a cash dividend lies in the direct payment of cash to shareholders. This payment is a fixed sum in proportion to the number of shares owned by the shareholder.

The transaction involves the transfer of funds either directly to the bank account or to the brokerage account.

The number of shares held by an investor remains unchanged after receiving cash dividends.

Cash dividends are taxable, and shareholders are subject to taxation based on the received cash, regardless of whether the share is sold.

Stock Dividend

Stock dividends involve the distribution of additional shares to existing shareholders instead of cash. The allocation is in a certain proportion to the number of shares already held.

The transaction results in the transfer of additional shares to the brokerage account of the shareholder.

Stock dividends increase the total number of shares held by the investor, effectively expanding their ownership stake in the company.

Stock dividends are generally not taxable unless the additional shares are sold. The tax treatment is deferred until the sale of the shares.

Considerations for Management

Both methods provide a means for companies to share profits with shareholders, each catering to different investor preferences and financial objectives. The choice between cash and stock dividends requires careful consideration by the management or board of directors. Factors influencing this decision include the financial strength of the company, shareholder preferences, and the overall business strategy.

Dividend Advantages and Disadvantages

Let’s take a look at the advantages and disadvantages of dividends to gain insights into how these financial decisions impact investors and businesses alike.

Advantages

• Income for Shareholders: Dividends provide a regular source of income for shareholders, especially those seeking steady returns on their investments.
• Market Confidence: Regular dividend payments can instil confidence in the market, signalling financial stability and a history of profitability.
• Investor Loyalty: Consistent dividend payments can foster loyalty among shareholders, encouraging them to stay invested in the company.
• Tax Benefits: You do not pay tax on any dividend income that falls within your Personal Allowance. Anything above the set allowance is subject to tax. Visit the UK government website for more information.
• Discipline in Capital Allocation: The commitment to paying dividends may enforce discipline in capital allocation, preventing reckless spending or unnecessary risk-taking.

Disadvantages

• Reduced Capital for Growth: Distributing dividends reduces the capital available for company expansion, research and development, or strategic acquisitions.
• Market Expectations: Establishing a pattern of regular dividend payments may create market expectations that are challenging to meet, potentially leading to negative reactions if dividends are reduced or suspended.
• Share Price Impact: The announcement of dividend payments can lead to a decrease in the company’s stock price, impacting shareholder wealth.
• Tax Implications: Dividends are often subject to taxation, reducing the net income received by shareholders. This can affect the attractiveness of dividend-paying stocks.
• Preference for Growth: Investors seeking capital appreciation and long-term growth may prefer companies that reinvest profits for future expansion rather than distributing dividends.
• Market Conditions: Economic downturns or challenging market conditions may prompt companies to reduce or suspend dividend payments, disappointing income-oriented investors.
• Equity Dilution (in the case of stock dividends): Stock dividends can lead to equity dilution, reducing the proportional ownership of existing shareholders.
• Pressure on Cash Reserves: Maintaining a commitment to regular dividend payments may put pressure on cash reserves, limiting the company’s ability to weather economic downturns or invest in new opportunities.

Top FTSE Dividend Paying Stocks

The following three FTSE listed companies currently (November 2023) have some of the highest dividend yields in the market. Here we will provide an example of returns if you owned 100 shares in each company today.

• British American Tobacco (BATS): British American Tobacco plc is a British multinational company that manufactures and sells cigarettes, tobacco and other nicotine products. The company’s current dividend yield is 9.2%. If you owned 100 shares in BATS your dividend payment this quarter would have been £57.72.
• Imperial Brands (IMB): Imperial Brands plc is another British multinational tobacco company that has a dividend yield of 7.9%. If you owned 100 shares in IMB your dividend payment this quarter would have been £21.59.
• Lloyds Banking Group (LLOY): Lloyds Banking Group plc is a British bank that has a dividend yield of 6.4%. The bank typically pays two dividends per year. If you owned 100 shares in LLOY your dividend payment would have been £0.92.

Key Takeaways

Dividends are an important component of investing and corporate finance. Here are 5 key takeaways to take with you:

• Not all companies pay dividends. Dividend payments can stop at any time.
• Dividends are a portion of a company’s profits paid out to shareholders, usually on a quarterly basis. They provide a steady income stream for investors.
• There are different types of dividends – the two most common being cash and stock dividends.
• Dividend payments follow a chronology – declaration, holder of record, ex-dividend, and payment dates. Understanding these dates is crucial for shareholders.
• Dividends can impact share prices, generally causing a decrease around the ex-dividend date. However, consistent dividends may increase investor confidence.
• Dividends have pros and cons – they provide income but reduce capital for growth. Companies weigh these factors in setting dividend policies.

FAQs

Dividends are an important yet sometimes confusing part of investing. Below are answers to some of the most frequently asked questions about dividends.