What is a Cumulative Dividend?
A cumulative dividend is a required fixed distribution of earnings made to shareholders. Preferred shares are the most common type of share class that provides the right to receive cumulative dividends. If a company is unable to distribute dividends to shareholders in the period owed, the dividends owed are carried forward until they are paid. In addition, the dividends must be paid before common shareholders receive a dividend.
Formula for Cumulative Dividend
To calculate the dollar amount of a cumulative dividend, use the following formula:
- Dividend Rate is the expected dividend payment expressed as a percentage on an annualized basis.
- Par Value is the face value for a share.
Note: The dividend rate and par value can be found on a preferred stock prospectus.
Key Features of a Cumulative Dividend
As opposed to non-cumulative (regular) dividends, a cumulative dividend comes with the following key features:
1. Fixed dividend payment
A cumulative dividend pays a fixed dividend amount depending on the dividend rate and par value of the stock. In other words, the dividend must be paid regardless of company profitability.
2. Seniority in dividend payments
Preferred shareholders with a cumulative dividend feature must be paid first before any dividends can be paid to common shareholders.
3. Accumulation of dividend payments
If a company is unable to pay a cumulative dividend in the year outstanding, the dividend amount accumulates until the company settles the amount outstanding.
Preferred Stocks and Cumulative Dividends
Preferred stock is a higher class of share ownership in that the owner of a preferred stock exercises a higher claim on assets of the company. Although not always, preferred shares commonly include a cumulative dividend feature. In addition, dividends attributed to preferred shares must be paid out first before any dividends are paid to common shares.
It is important to note that preferred stock is commonly called a hybrid security, because of its inherent “equity” and “debt” features.
1. Equity feature
Preferred shares are similar to common shares in that they represent an ownership interest and the share price value can appreciate.
2. Debt feature
Preferred stock is similar to debt in that a preferred stockholder is paid a fixed dividend periodically (i.e., a cumulative dividend).
Examples of a Cumulative Dividend
1. New preferred share issue
Colin is looking to invest in the new preferred share issue of ABC Company. He would like to determine the dividends to be received per share of preferred stock owned. On the preferred stock prospectus, he notices that the dividend rate is 5% with a par value of $100.
If Colin were to purchase 1,000 preferred shares of ABC Company, assuming that the preferred shares come with a cumulative dividend feature payable once a year, how much in dividends is he entitled to annually?
Cumulative Dividend = 5% x $100 = $5 (Dividend per preferred share)
Since Colin is looking to purchase 1,000 preferred shares, he would be entitled to $5,000 annually.
2. Preferred shares during an economic downturn
Colin recently purchased 1,000 preferred shares of ABC Company. Unfortunately, Colin bought the preferred shares during an economic downturn. The company later issued a warning to shareholders that its company would not be able to pay dividends to all shareholders during this year’s operation and, accordingly, decided to carry forward dividend payments on preferred shares. What would happen to Colin’s dividend payment in the current year?
If ABC Company is unable to pay dividends in the current year to preferred shareholders, the dividend amount is carried forward to later years. If the company is unable to pay dividends in Year 1 and then declares a dividend payment to preferred shares in Year 2, Colin would be receiving $10,000 in dividends ($5,000 owed from Year 1 and $5,000 entitled in Year 2).
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