Dividends are payments disbursed to shareholder members of a corporation on a regular basis, typically quarterly. These payments represent the shareholder’s part of a company’s profits. A dividend is designated as a fixed or set amount per share, which means that each shareholder receives a dividend proportional 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 the total dividend amount by the total number of shares outstanding. Dividend yield refers to 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.
|Types of Dividends||Description|
|Cash dividends||This type of dividend is the most common and is disbursed as currency, by way of an electronic funds transfer or physical check. For each share owned, a specific determined amount of money is distributed. For instance, if an individual owns 1000 shares with a cash dividend value of $0.90 per share, the shareholder will receive a total amount of $900.|
|Stock dividends||Also known as scrips, this type of dividend is a payment 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 their earnings towards the growth of the company, rather than diverting them into cash dividends for shareholders.|
|Property dividends||Also known as dividends in specie (Latin for “in kind”), this type of dividend is disbursed in the form of assets from the distributing corporation or one of its subsidiary corporations. This type of dividend is somewhat rare and can also be expressed as securities of other companies owned by the distributor, or products and services.|
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 stockholders 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 reinvested 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.
Economists Modigliani and Miller put forth a theory that only the firm’s ability to earn money and the 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:
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.
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.
Generally speaking, a high yield stock is one with a dividend yield greater than the yield of any benchmark average like the 10-year U.S. Treasury note. However, since there is no set standard for determining if a dividend’s yield is high or low, a high yield stock’s classification is contingent upon the particular benchmarks used by any given analyst.
EXAMPLESome may deem a 2% yield to be high for a dividend, while others regard this as low.
A high dividend yield hints at undervaluation of the stock, because the dividend is high compared to the price of the stock, making this one that tends to be pursued by income and value investors. These high yield stocks are apt to perform better than low yield or no yield stocks in bear markets, as a lot of investors believe stocks that pay dividends pose less risk.
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 the 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 a 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.
Advocates of the Dogs of the Dow strategy contend that blue chip companies do not adjust their dividend based upon trading conditions. Thus, the dividend is a barometer of the company’s average worth. Conversely, the stock price vacillates throughout the business cycle. This should translate to a scenario whereby corporations with a high yield, meaning high dividend relative to stock price, are close to the bottom of their business cycles and are expected to witness an increase in their stock price that occurs more rapidly than low yield companies.
Utilizing this model, an investor who reinvests in high yield companies every year should exceed the overall market. The logical assumptions behind this theory are that a high dividend yield implies the stock is oversold and that management feels confident about the company’s prospects - enough to back it up by an outlay of relatively high dividends. In this case, investors expect to profit from above average stock gains and comparably high quarterly dividends.
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.
Source: THIS CONTENT HAS BEEN ADAPTED FROM LUMEN LEARNING'S “Introduction to Dividends” TUTORIAL.