All About Dividends
Declaration, Ex-Dividend Date, Cash and Property Dividends
Companies that earn a profit can do one of three things: pay that
profit out to shareholders, reinvest it in the business through
expansion, debt reduction or share repurchases, or both. When a
portion of the profit is paid out to shareholders, the payment is
known as a dividend.
During the first part of the twentieth century, dividends were the
primary reason investors purchased stock. It was literally said on
Wall Street, the purpose of a company is to pay dividends. Today, the
investors view is a bit more refined; it could be stated, instead, as,
the purpose of a company is to increase my wealth. Indeed, todays
investor looks to dividends and capital gains as a source of increase.
Microsoft, for example, did not pay a dividend until it had already
become a $350 billion company, long after making the companys founders
and long-term shareholders multi-millionaires or billionaires.
The Process
Dividends must be declared (i.e., approved) by a companys Board of
Directors each time they are paid. There are three important dates to
remember regarding dividends.
Declaration date: The declaration date is the day the Board of
Directors announces their intention to pay a dividend. On this day,
the company creates a liability on its books; it now owes the money to
the stockholders. On the declaration date, the Board will also
announce a date of record and a payment date.
Date of record: This date is also known as ex-dividend date. It is the
day upon which the stockholders of record are entitled to the upcoming
dividend payment. According to Barrons, a stock will usually begin
trading ex-dividend or ex-rights the fourth business day before the
payment date. In other words, only the owners of the shares on or
before that date will receive the dividend. If you purchased shares of
Coca-Cola after the ex-dividend date, you would not receive its
upcoming dividend payment; the investor from whom you purchased your
shares would.
Payment date: This is the date the dividend will actually be given to
the shareholders of company.
A vast majority of dividends are paid four times a year on a quarterly
basis. This means that when an investor sees that Coca-Cola pays an
$0.88 dividend, he will actually receive $0.22 per share four times a
year. Some companies, such as McDonalds, pay dividends on an annual
basis.
Types of Dividends
Cash DividendsRegular cash dividends are those paid out of a companys
profits to the owners of the business (i.e., the shareholders). A
company that has preferred stock issued must make the dividend payment
on those shares before a single penny can be paid out to the common
stockholders. The preferred stock dividend is usually set whereas the
common stock dividend is determined at the sole discretion of the
Board of Directors (for reasons discussed later, most companies are
hesitant to increase or decrease the dividend on their common stock).
You can find a detailed discussion of preferred stock and its dividend
provisions in The Many Flavors of Preferred Stock: A Possible
Investment for Your Fixed Income Portfolio.
Property DividendsA property dividend is when a company distributes
property to shareholders instead of cash or stock. Property dividends
can literally take the form of railroad cars, cocoa beans, pencils,
gold, silver, salad dressing or any other item with tangible value.
Property dividends are recorded at market value on the declaration
date.
Special One-Time DividendsIn addition to regular dividends, there are
times a company may pay a special one-time dividend. These are rare
and can occur for a variety of reasons such as a major litigation win,
the sale of a business or liquidation of a investment. They can take
the form of cash, stock or property dividends. Due to the temporarily
lower rates of taxation on dividends, there has been an increase in
special dividends paid in recent years.
To add sugar to spice, there are times when these, special one-time
dividends are classified as a return of capital. In essence, these
payments are not a payout of the companys profits but instead a return
of money shareholders have invested in the business. As a result,
return of capital dividends are tax-free.
Special one-time dividends sometimes offer an opportunity for arbitrage.
Stock Dividends - An Explanation and Example
Stock Dividends
A stock dividend is a pro-rata distribution of additional shares of a
companys stock to owners of the common stock. A company may opt for
stock dividends for a number of reasons including inadequate cash on
hand or a desire to lower the price of the stock on a per-share basis
to prompt more trading and increase liquidity (i.e., how fast an
investor can turn his holdings into cash). Why does lowering the price
of the stock increase liquidity? On the whole, people are more likely
to buy and sell a $50 stock than a $5,000 stock; this usually results
in a large number of shares trading hands each day.
A practical example of stock dividends:
Company ABC has 1 million shares of common stock. The company has five
investors who each own 200,000 shares. The stock currently trades at
$100 per share, giving the business a market capitalization of $100
million.
Management decides to issue a 20% stock dividend.
It prints up an additional 200,000 shares of common stock (20% of 1
million) and sends these to the shareholders based on their current
ownership. All of the investors own 200,000, or 1/5 of the company, so
they each receive 40,000 of the new shares (1/5 of the 200,000 new
shares issued).
Now, the company has 1.2 million shares outstanding; each investor
owns 240,000 shares of common stock. The 20% dilution in value of each
share, however, results in the stock price falling to $83.33. Heres
the important part: the company (and our investors) are still in the
exact same position. Instead of owning 200,000 shares at $100, they
now own 240,000 shares at $83.33. The companys market capitalization
is still $100 million.
A stock split is, in essence, a very large stock dividend. In cases of
stock splits, a company may double, triple or quadruple the number of
shares outstanding. The value of each share is merely lowered;
economic reality does not change at all. It is, therefore, completely
irrational for investors to get excited over stock splits. If you do
not still fully understand this, you must read How to Think About
Share Price. It will clear up any lingering confusion.
One of the more interesting theories of corporate dividend policy is
that managements should opt for stock dividends over all other kinds.
This will allow investors that want their earnings retained in the
business (and not taxed) to hold on to the additional stock paid out
to them. Investors that want current income, on the other hand, can
sell the shares they receive from the stock dividend, pay the tax and
pocket the cash - in essence, creating a do-it-yourself dividend.
Corporate Dividend Policy, Dividend Payout Ratio and Dividend Yield
Dividend Policy
Are high dividends good or bad? The answer depends upon your
personality, financial circumstances and the business itself.
In Determining Dividend Payout: When Should Companies Pay Dividends?,
you learned that, a company should only pay dividends if it is unable
to reinvest its cash at a higher rate than the shareholders (owners)
of the business would be able to if the money was in their hands. If
company ABC is earning 25% on equity with no debt, management should
retain all of the earnings because the average investor probably won't
find another company or investment that is yielding that kind of
return.
At the same time, an investor may require cash income for living expenses.
In these cases, he is not interested in long-term appreciation of
shares; he wants a check with which he can pay the bills.
Double taxation - the political debate over dividends
Dividends, like interest, are taxed at a persons individual tax rate.
Capital gain taxes, on the other hand, are assessed according to the
length of time an investor held his investment and can be as low as
half the rate levied on dividends income. This difference in tax
treatment is another reason many investors opt for long-term equity
holdings that reinvest capital into the business instead of paying it
out in the form of a dividend; by avoiding the double-taxation, they
can compound their wealth at a faster rate.
There is a significant political controversy over the fact that
profits paid out as dividends are subject to double-taxation. The
corporation paid income taxes on the profit it earned (original tax).
The owners of the business then take that profit out for their
personal use in the form of a dividend and are taxed at personal
income tax rates (second tax). In effect, they have paid the
government twice.
The proponents of the dividend tax argue that the wealthy, by
definition, own significantly more investments than the poor.
Therefore, it would be possible for someone to earn billions of
dollars in dividend income and not pay a dime in Federal taxes. This,
they say, is inherently unfair. The gap between the rich and the poor
would explode over night.
For more information and potential solutions, read Dividend Tax - The
Political Debate: Understanding the Double Taxation Fuss.
Dividend Payout Ratio
The percentage of net income that is paid out in the form of dividend
is known as the dividend payout ratio. This ratio is important in
projecting the growth of company because its inverse, the retention
ratio (the amount not paid out to shareholders in the form of
dividends), can help project a companys growth.
Calculating Dividend Payout Ratio
Coca-Colas 2003 cash flow statement shows that the company paid $2.166
billion in dividends to shareholders. The income statement for the
same year shows the business had reported a net income of $4.347
billion. To calculate the divided payout ratio, the investor would do
the following:
$2,166,000,000 dividends paid---------(divided
by)---------$4,347,000,000 reported net income
The answer, 49.8%, tells the investor that Coca-Cola paid out nearly
fifty percent of its profit to shareholders over the course of the
year.
Dividend Yield
The dividend yield tells the investor how much he is earning on a
common stock from the dividend alone based on the current market
price. Dividend yield is calculated by dividing the actual or
indicated annual dividend by the current price per share.
The Washington Post pays an annual dividend of $7 and trades at $910
per share; Altria Group (formerly Philip Morris) pays an annual
dividend of $2.72 and trades at $49.75 per share. By calculating
dividend yield, the investor can compare the amount he would earn in
cash income annually from each security.
Washington Post Dividend Yield Calculation$7.00----(divided by)----$910
= 0.0077 or 0.77%
Altria Group Dividend Yield Calculation$2.72----(divided by)----$49.75
= 0.055 or 5.5%
In other words, despite the fact that the Washington Post pays a
higher per-share dividend, $100,000 invested in its common stock would
yield only $770 in annual income as opposed to the same amount
invested in Altria Group which would yield $5,500. An investor
interested in dividend income and not capital gains should opt for the
latter, all else being equal.
Selecting High Dividend Stocks
Selecting high dividend stocks
An investor desiring to put together a portfolio that generates high
dividend income should place great scrutiny on a companys dividend
payment history. Only those corporations with a continuous record of
steadily increasing dividends over the past twenty years or longer
should be considered for inclusion. Furthermore, the investor should
be convinced the company can continue to generate the cash flow
necessary to make the dividend payments; a handgun manufacturer, for
example, may have a long history of high dividend payments while
generating strong cash flow from operations yet not make a good
investment because it faces litigation which, if successful, will
bankrupt the business.
Dividends related to cash flow - not reported earnings
This brings up an important point: dividends are dependent upon cash
flow, not reported earnings.Almost any Board of directors would still
declare and pay a dividend if cash flow was strong but the company
reported a net loss on a GAAP basis. The reason is simple: investors
that prefer high dividend stocks look for stability. A company that
lowers its dividend is probably going to experience a decline in stock
price as jittery investors take their money elsewhere. Companies will
not raise the dividend rate because of one successful year; so afraid
are they of lowering the dividend they will wait the business is
capable of generating the cash to maintain the higher dividend payment
forever. Likewise, they will not lower the dividend if they think the
company is facing a temporary problem.
Debt restrictions
Many companies are not able to pay dividends because bank loans, lines
of credit or other debt financing places strict limitations on the
payment of common stock dividends. This type of covenant restriction
is disclosed in a companys 10K filing with the SEC.
DRIPs -Dividend Reinvestment Plans
Unless you need the money for living expenses or you are an
experienced investor that regularly allocates capital, the first thing
you should do when you acquire a stock that pays a dividend is enroll
it in a dividend reinvestment plan, or DRIP for short.
How dividend reinvestment plans work
When an investor enrolls in a dividend reinvestment plan, he will no
longer receive dividends in the mail or directly deposited into his
brokerage account. Instead, those dividends will be used to purchase
additional shares of stock in the company that paid the dividend.
There are several advantages to investing in DRIPs; they are:
Benefits of enrolling in a dividend reinvestment plan
Enrolling in a DRIP is easy. The paperwork (both online and in print)
can normally be filled out in under one minute.
Dividends are automatically reinvested. Once the investor has enrolled
in a DRIP, the process becomes entirely automated and requires no more
attention or monitoring.
Many dividend reinvestment plans are often part of a direct stock
purchase plan. If the investor holds at least one of his shares
directly, he can have his checking or savings account automatically
debited on a regular basis to purchase additional shares of stock.
Purchases through dividend reinvestment programs are normally subject
to little or no commission.
Dividend reinvestment plans allow the investor to purchase fractional
shares. Over decades, this can result in significantly more wealth in
the investors hands.
An investor can enroll only a limited number of shares in the dividend
reinvestment plan and continue to receive cash dividends on the
remaining shares.
Practical examples of dividend reinvestment plans in action
Full enrollment in a DRIP Jane Smith owns 1,000 shares of Coca-Cola.
The stock currently trades at $50 per share and the annual dividend is
$0.88 per share. The quarterly dividend has just been paid ($0.88
divided by 4 times a year = $0.22 per share quarterly dividend).
Before she enrolled in Coca-Colas dividend reinvestment plan, Jane
would normally receive a cash deposit of $220 in her brokerage
account. This quarter, however, she logs into her brokerage account
and finds she now has 1,004.40 shares of Coca-Cola. The $220 dividend
that was normally paid to her was reinvested in whole and fractional
shares of the company at $50 per share.
Partial enrollment in a DRIP William Jones owns 500,000 shares of
Altria group. The stock currently trades at $49.75 and pays an
indicated annual dividend of $2.72 per share ($0.68 per quarter).
William would like to receive some cash for living expenses but would
like to enroll some of the shares in a DRIP. He calls his broker and
has 300,000 shares enrolled in Altrias DRIP.
When the quarterly dividend is paid, William will receive cash
dividends of $136,000. He will also receive 4,100.50 additional shares
of Altria Group giving him holdings of 304,100.50 shares (300,000
shares * $0.68 dividend = $204,000 divided by $49.75 per share price =
4,100.50 new shares of Altria Group).
Dividends on dividends
Why are dividend reinvestment plans conducive to wealth building?
Notice that William now has 4,100.50 additional shares of Altria
stock. When the next quarterly dividend is paid, he will receive $0.68
for each of those shares. That additional income works out to
$2,788.34. Those dividends will be partially reinvested in the stock,
buying more shares which will pay more dividends.
In even the smallest portfolio, dividend reinvestment plans can result
in substantial increases in value over extended periods of time. To
demonstrate the power of dividend reinvestment through DRIPs, consider
the example given in Jerry Edgerton and Jim Fredericks August 1, 1997
Money magazine article, Build Your Wealth Drip by Drip: if you had put
$10,000 in Standard & Poors 500 stock index at the end of 1985 and not
bothered to reinvest your dividends, you would have had $29,150 by the
end of 1995. Had you reinvested the dividends, however, your total
would have been more than $40,000.
In other words, reinvesting those seemingly-small dividends resulted
in an extra $10,850 over ten years. Assuming you continued to add to
your principal investment and held those stocks for thirty or forty
years, the difference could be hundreds of thousands of dollars or
more.
