Updated July 20, 2023
Introduction to Dividend
A dividend is a portion of the profit that is paid out by public companies to the shareholders. It is not mandatory for a company to pay it. It is not an expense but a percentage share of profit that is decided by the Board of Directors of the company.
It is the distribution that is made by the company from the after-tax portion of the profit. Many Mutual Funds buy stocks that pay regular stable dividends. Many Mutual Funds are under regulations that don’t allow them to buy Non-Dividend paying stocks. Mature companies mainly engage in such payments as they don’t have scope for fresh investments. So instead of retaining profits as a reserve, they pay them as dividends.
How Does It Work?
Public limited companies raise money from the public by selling shares. When an investor buys shares of a company, then that investor becomes the shareholder of the company. Shareholders are also owners of the company. So when a company makes a profit, then the Board of Directors of the company decide whether the profit should be retained in the business or paid as a dividend to the shareholders. Generally, a percentage of profit is retained in the business for future growth prospects, and the rest is distributed to shareholders.
Example of Dividend
Company ABC is a public limited manufacturing company that operates from the United States. The company is matured and doesn’t have the scope for fresh investments in the market. The company made a profit of $500,000 this quarter and plans to pay a dividend to the shareholders. Total shares outstanding for ABC is 100,000. The pay-out percentage is 50%. Calculate the dividend per share.
- Net Profit = 500,000
- Pay-Out Ratio = 50%
- Number of Shares Outstanding = 100,000
It is calculated using the formula given below
Dividend Per Share = (Net Profit * Pay-Out Ratio) / Number of Shares Outstanding
- Dividend Per Share = (500,000 * 50%) / 100,000
- Dividend Per Share = 2.5
This means that each shareholder will receive $2.5 as a dividend.
Types of Dividend
There are several types that a company can announce.
- Cash Dividend: When the Board of Directors plans to start paying dividends to shareholders, then the policy is formed. The cash is also referred to as an ordinary dividend and is paid from the regular profit of the business.
- Additional Dividend: At times companies plan to pay more dividends to shareholders as a bonus. When the extra dividend is paid from the same regular yearly profit, then that is called an additional dividend.
- Special Dividend: If in a particular year, the company makes a sudden profit that is not part of regular operation. Then that earning can be distributed to shareholders as a form of a special dividend. There is no guarantee that a company will pay a special dividend, it happens in rare occasions.
- Stock Dividend: When a company issues additional stocks to shareholders, then that is called a stock dividend. The amount that is equal to the fair value of stocks is transferred from the reserve account to the capital account.
- Liquidating Dividend: Poorly running public limited companies are often liquidated and the proceeds are paid to debt holders first and the remaining amount is paid to equity shareholders as liquidating dividends
These are taxable, but the tax rate depends on whether the dividend is qualified or nonqualified.
For a dividend to be qualified, there are certain criteria, the dividend must be paid by a U.S. company, or a company in U.S. possession, or a foreign company stock that has the right to freely trade in US market, or a foreign company operating from a country that benefits from U.S tax treaty.
When it is qualified, the tax slab is different. Lower tax slabs are exempted for qualified dividends. If it is nonqualified, then that dividend will be taxed as normal regular income.
There are 4 important dates associated:
- Announcement Date: This is the date when the company first announces that they plan to pay a dividend. Usually, the announcement is made as a press release.
- Ex-Date: If a person buys the share of the company on this date, then the person will not receive the dividend from the company. To get that is announced, an investor must buy the share at least one day prior to Ex-Date
- Record Date: On this date, the company checks its Record Book and sees the name of the shareholders. These shareholders will be eligible to receive the payment on the pay-date of the dividend.
- Pay-Date: The amounts are transferred to the shareholder’s accounts on this date. Actual payment is made.
Effect of Dividend on Share Price
This is either paid from the reserve or from the regular yearly profit of the company. Once the cash goes out of the company, it is obvious that the valuation of the company will not remain the same. The effect happens on the Ex-Date. On the Ex-Date of the Dividend, the share price gets reduced by the amount.
Difference Between Dividend and Buyback
The dividend is being treated as a fixed commitment from the company by the shareholders. Once a company starts to pay, then that company is expected to pay dividends forever. So this is sticky. On the other hand, buyback is not sticky. Whenever a company has extra cash, then that company can go for buyback of shares. Buyback is actually buying back of shares from the shareholders at a premium price. These leave the shareholders happy and the company will not have to repeat the procedure at a fixed interval of time.
These are a way by which a company shares profit to its shareholders. Many big companies maintain a steady rate of dividend in order to enjoy the goodwill in the market. Matured companies usually engage in paying dividends. There is no mandatory rule that a company will have to pay a dividend.
This is a guide to Dividend. Here we also discuss the introduction to Dividend, how does it work, along with several types. You may also have a look at the following articles to learn more –