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Understanding Dividends: A Comprehensive Guide to Dividend Types, Yield, and Valuation Impact
A method of sharing profit with investors
What is a Dividend?
A dividend is a portion of a company’s profits that is paid out to its shareholders. When a company accumulates retained earnings, management can choose to reinvest in the business to fuel growth, pay off debts, or save for future needs. Alternatively, management can decide to share some of these profits with shareholders. This profit sharing is called a dividend.
Types of Dividends: Cash and Stock
Cash dividends are paid out in cash, which means shareholders receive payments that are deposited directly into their accounts. For example, if you own shares in a company and that company decides to pay a dividend of $2 per share, you would receive $2 for every share you own. If you have 10 shares, that’s $20 in dividend income. These payments are usually made on a regular schedule, often quarterly (every three months), though not all companies pay dividends.
Some companies issue dividends as additional shares of stock instead of cash, which allows shareholders to increase their ownership in the company without having to buy more shares.
The Importance of Dividends for Investors
Dividends are an essential part of many investors’ strategies, especially those who are looking for a steady income stream from their investments. Companies, mutual funds, and exchange-traded funds that pay regular dividends are often seen as stable and profitable, making them attractive to investors who prefer lower-risk opportunities.
Key Highlights
- When a company generates a profit and accumulates retained earnings, those earnings can be either reinvested in the business or paid out to shareholders as a dividend.
- A dividend’s value is determined on a per-share basis and is paid equally to all shareholders of the same class. The payment must be approved by the Board of Directors.
- A company may also return cash to shareholders via a share buyback.
How Do Dividends Work?
Understanding how dividend payments work is essential for anyone interested in investing in or analyzing dividend-paying businesses.
Step 1: The Company Decides to Pay a Dividend
The first step in the dividend payment process begins with the company. When a company makes a profit, its board of directors decides whether to pay out a portion of these profits as dividends to shareholders. This decision is based on factors like the company’s financial health, future growth plans, and overall business strategy.
Once the decision is made, the company announces the dividend amount per share and the schedule for payment. This announcement informs shareholders about the expected dividend they will receive.
Step 2: Important Dates You Need to Know
There are several key dates to keep in mind when it comes to dividend payments:
- Declaration Date: This is the date when the company officially announces its intention to pay a dividend. The declaration includes the dividend amount, payment date, and other relevant details.
- Ex-Dividend Date: The ex-dividend date is the cutoff day to be eligible for the dividend. If you purchase shares on or after this date, you will not receive the upcoming dividend. The ex-dividend date is usually set one or two business days before the record date.
- Record Date: The record date is when the company looks at its records to determine who the eligible shareholders are. If you own shares on this date, you will receive the dividend.
- Payment Date: This is the date when the dividend is actually paid out to shareholders. On this day, you will receive the dividend income, either in cash or additional shares, depending on the type of dividend.
Step 3: Receiving Your Dividend Payment
Once the payment date arrives, the company distributes the dividend to all eligible shareholders. If you’re receiving a cash dividend, the money will be deposited into your brokerage or bank account. If it’s a stock dividend, you’ll receive additional shares in the company.
For example, if you own 100 shares of a company and they pay a $1 dividend per share, you will receive $100 in dividend income. This payment is often deposited directly into your bank account, so there’s no need to take any action on your part. However, dividend income can include a tax liability, such as capital gains tax or income tax, so it’s important to speak to a tax professional about any dividend-paying stocks you own and dividend payments received.
Step 4: Reinvesting Dividend Income for Growth
Many investors choose to reinvest their dividend income to buy more shares of the same stock. Reinvesting dividends can be a powerful way to grow your investment over time, as it allows you to benefit from compounding. Over the long term, this can significantly increase your stock holdings and potential future dividend income. Many companies offer dividend reinvestment plans (DRIP) to help shareholders reinvest dividends.
Why Do Companies Pay Dividends?
One of the primary reasons companies pay dividends is to signal financial health and stability. When a company regularly pays dividends, it sends a message to the market and its shareholders that it is profitable and has a steady stream of income. This can build investor confidence, as consistent dividend payments suggest that the company is generating enough profit to share with its shareholders while still investing in its own growth.
By paying dividends, a company demonstrates that it has reached a level of maturity where it can afford to distribute some of its profits without compromising its operations or growth potential. This is particularly important for companies in industries that are perceived as stable and low-risk, such as utilities or consumer goods.
How are Dividend Amounts Determined?
The amount of a dividend is typically determined by the company’s leadership, usually the board of directors, after reviewing the company’s financial performance. The primary goal is to strike a balance between rewarding shareholders and retaining enough capital to support future growth and operations.
To set a dividend amount, the board assesses the company’s net income, or what’s left after all expenses have been paid. Then, the company decides how much to allocate toward dividends versus how much to reinvest in the business. This allocation reflects the company’s confidence in its financial health and future prospects.
Key Factors Influencing Dividend Payouts
Several key factors influence how much a company’s earnings it decides to pay in dividends, including:
- A company’s earnings and profit levels
- Business growth plans
- Industry norms
- Financial stability
Understanding Dividend Yield and Its Significance
Dividend yield is a key metric that investors use to assess a dividend’s value relative to its stock price. It is calculated by dividing the annual dividend per share by the current stock price and is expressed as a percentage.
For example, if a company pays an annual dividend of $2 per share and its stock is priced at $40, the dividend yield would be 5% ($2 ÷ $40 = 0.05, or 5%). A higher yield can make an investment in a company’s stock more attractive to income-focused investors, as it indicates a higher return on their investment through dividends.
However, while a high dividend yield may seem appealing, it’s important to consider the sustainability of that yield. If the yield is high because the share price has dropped significantly, it could signal underlying issues within the company. Therefore, yield should be evaluated alongside other financial metrics to get a complete picture of the company’s health and prospects.
Dividend Example
Below is an example from General Electric’s (GE)’s quarterly 2017 financial statements. As you can see in the screenshot, GE declared a dividend per common share of $0.84 in 2017, $0.93 in 2016, and $0.92 in 2015.
This figure can be compared to Earnings per Share (EPS) from continuing operations and Net Earnings for the same time period.
Dividends in Financial Statements
When a company pays a dividend, it is not considered an expense on the income statement since it is a payment made to the company’s shareholders. This differentiates it from a payment for a service to a third-party vendor, which would be considered a company expense.
Dividend vs. Buyback
Corporations have several types of distributions they can make to the shareholders. The two most common distribution types are dividends and share buybacks. A share buyback is when a company uses cash on the balance sheet to repurchase shares in the open market.
Share buybacks are a way to both return cash to shareholders and reduce the number of shares outstanding, which can help boost a company’s earnings per share (EPS). When the number of shares decreases, the denominator in EPS (net earnings/shares outstanding) decreases; thus, EPS increases. Corporations are frequently evaluated on their ability to move share price and grow EPS, so they may be incentivized to use the buyback strategy.
Impact of a Dividend on Valuation
Paying dividends has no impact on the enterprise value of the business. However, it does lower the equity value of the business by the value of the dividend that’s paid out.
Dividends in Financial Modeling
In financial modeling, it’s important to have a solid understanding of how a dividend payment impacts a company’s balance sheet, income statement, and cash flow statement. In CFI’s financial modeling courses, you’ll learn how to link the financial statements together so that any dividends paid flow through all the appropriate accounts.
A well-laid-out financial model will typically have an assumptions section where any return of capital decisions are contained. For example, if a company is going to pay a dividend in 2024, then there will be an assumption about what the dollar value will be, which will flow out of retained earnings and through the cash flow statement (financing activities), which will also reduce the company’s cash balance.
Additional Resources
Dividend vs Share Buyback/Repurchase
