Dividend is that portion of profit which is distributed to the shareholders of the company as the reward for their investment in the company and its distribution amount is decided by the board of the company and thereafter approved by the shareholders of the company.
In simple words, Dividend is typically the share of profit (after tax) of a company to its shareholders. It is a form of return that the shareholder of the company gets for investing money in the company.
How does it work?
Profits earned by a company are majorly invested in two ways, they either re-invest the complete profit into the company (also known as retained earnings) or give a part of it back to its shareholders.
- Once the company has paid off the liabilities/creditors, the company can decide on paying part or full of its profits to shareholders in the form of a dividend payment. However, this payment is not mandatory for a company. For example, if a company faces a cash crunch or is planning on a CAPEX, it can decide on not paying this for that year.
- Further, the amount to be paid is decided by the board of directors of the company along with the shareholder’s approval (Taken via voting rights).
- It can be paid in cash or in the form of stocks or buyback offers, etc. When a company decides on paying dividends, it fixes a record date. Everyone holding the shares of the company on that day is eligible for receiving the payments. It is a fixed amount decided to be paid on per share basis. The further frequency of payments varies from company to company. Smaller companies usually pay it once a year while larger companies might have a quarterly schedule of payments.
They are majorly paid in 2 forms:
- Cash Dividend: This is the most common form. Cash payments are paid out in the currency either in the form of direct electronic transfers to the account of the shareholder or hard cheques sent to the shareholder’s address. They are taxable and are doubly taxed both at the company’s and shareholder’s end as per most of the country’s tax laws. The company has to pay dividend distribution tax and the shareholders have to pay normal income tax.
- Stock Dividend: It is another form of distribution wherein instead of paying out cash to the shareholders, the company decides on issuing additional shares to the shareholders thus increasing the total invested capital of the shareholders. If the company is performing well, this type of situation is a win-win for both companies and shareholders since the shareholder will be more earning with the increasing market prices without any extra investment, and company will also not have to part with the profits for the year.
Chronology of Dividends
- Announcement/Declaration Date: Date on which the company’s management announced the dividend payments. The board decides on the amount to be paid and also the date on which it should be paid.
- Ex-Date: It is the date on which eligibility to receive dividends expires. For example: If a particular stock declares that the ex-date is March 25, all the shareholders who purchase the stock one day prior to the ex-date will only be eligible to receive payments.
- Date of Record: Record date is the date when the company decides on the list of shareholders to whom these are to be paid.
- Payment Date: Date on which dividend payments are issued to the company and this is transferred to the shareholder’s account.
A company XYZ limited had a good year and earned substantially high profits. The company decided to pay a dividend of $ 1 per share to its shareholders. Say Mr. P has bought 150 shares of the company at $20 per share. Thus his total investment in the company is $3000.
Thus, Mr. P would earn: $ 1 * 150 = $ 150
Thus, the dividend yield on stocks held would be = Total Dividend/Cost of stocks held
= $ 150/ $3000 = 5%
Importance of Dividends
#1 – For Shareholders
They are a regular source of income for a lot of shareholders. For instance, for a person who is retired and holds a significant amount of stocks as a part of his investment portfolio whose prices are increasing, he will not have a regular income from the stock in the form of cash till he sells them off. However, if there is a dividend payment from these stocks at regular intervals, he will have a continuous income source to handle his expenses without selling the stocks.
#2 – For Company
Dividend payments are very important for maintaining the trust of shareholders by giving them regular returns from their investment. It has been seen in a lot of cases that when a company decides on cutting on such payments, the share price of the company goes down because of negative sentiments in the market about the company’s stocks.
It might also be important for a company to pay dividends to maintain its financial ratios or to maintain the cyclical nature of its business. For example, for a textbook manufacturing firm, the major part of the business happens in Q1 and Q4 of the year. Thus, to maintain the share price of the stock, it may declare such payments in Q2 or Q3.
Important Points to Note
- Dividend yield of a particular company many a time deciding on the market sentiment about the stock. A higher yield leads to positive sentiment. However, the yield is compared to companies in the same industry.
- The company must be abreast with the taxation laws of their respective countries before its declaration. These laws change very frequently and hence attention needs to be paid to them. Usually, dividends are double-taxed. Once the company declares such payments, it has to pay dividend distribution tax, and again the shareholders have to pay income tax on them.
Thus, it usually helps the company boost the confidence of the investors in the shares of the company. While the flip side to it is that the company has to forego its cash income which it could have invested back in the company. Thus, the decision on dividend distribution needs to be taken basis future prospects of the company.
This has been a guide to what is Dividend & its definition. Here we discuss the chronology of dividends, why they are important for shareholders and the company. You can learn more about firms from the following articles –