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What is Dividends ? and How do They Work | Everything You Need to Know | Expert’s Top Picks

Last updated on 03rd Nov 2022, Artciles, Blog

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Swathi Gopinath (Software Engineer - MicroStrategy )

Swathi Gopinath, a software engineer at MicroStrategy, provides the most powerful, scalable, and user-friendly platforms for analytics, mobility, and security. She plays a role in enabling MicroStrategy products to be best-in-breed and optimized for leading organizations to analyze big data and distribute actionable business insight across their enterprise.

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    • In this article you will learn:
    • 1.What are Dividends?
    • 2.Types of Dividends.
    • 3.Impact of Cash Dividends.
    • 4.Impact on Financial Ratios.
    • 5.Dividend Payment Dates.
    • 6.What is Dividend Policy?
    • 7.Various Dividend Models.
    • 8.Conclusion.

What are Dividends?

In a Finance Management, dividends are the portion of a company’s profits paid out to its shareholders. When company earns a profit, there are two ways in which it can utilize a surplus funds. The company can either decide to the reinvest the profits in a business (retained earnings) or distribute it to the shareholders. The distribution of cash to shareholders takes two forms: one is a share repurchase, and other is dividends.In the most companies, a part of a profit is kept as retained earnings and remaining is distributed to a shareholders.The board of the directors of the company declares a dividends every year. In some jurisdictions, like UK, these board actions need the approval of shareholders. However, in the other jurisdictions such as US, such as approval may not be required.

  • Dividends are generally paid as a fixed amount of a per share. For example, $1 per share. Therefore, shareholders will receive dividends based on their holdings.
  • Unlike, a payment of interest and principal of a corporate bet, the payment of the dividends to common shareholders is not be mandatory, as based on a company’s performance; the company may decide not to pay dividends in the specific year.
  • Payment of dividend is not be considered an expense, rather is paid to the shareholders from after-tax profits. In a some jurisdictions, the dividends may be taxed at a shareholder level. The tax treatment of the dividends may also differ from a capital gains tax.
  • The dividends can be paid in a many forms like cash dividends, extra dividends, stock dividends, stock splits, and a reverse stock splits.
  • The payment of dividends is more important for a financial analysts as they affect a stock prices and the return on investments.
Types of Dividends

Types of Dividends:

A company can pay a dividends in more different forms. The most common form of a dividend payment is cash dividends. Let’s take a look at the different forms of the dividends:

Cash Dividends: A company may decide to pay the dividends in a form of cash based on the schedule. Cash dividends can be a regular dividends, special dividends, or liquidating dividends.

Stock Dividends: In this case, a company pays dividends as a new stocks, rather than cash.

Stock Splits: In this case, a company decides to split each share into the multiple shares. A 2-for-1 stock split means each old stock is be split into the two new stocks.

Reverse Stock Splits: Reverse stock splits are work exactly opposite to a stock splits. Instead of a splitting shares, multiple shares are combined into the fewer shares. For example a 1-for-2 reverse stock split means 1 new share is issued for an each two old shares.

Cash Dividend:

Cash dividends can be in a form of regular dividends, special dividends or a liquidating dividends:

Regular Dividends: These are dividends that companies’ pay based on the regular It is important for the companies to maintain a stable record as it is seen as sign of a financial stability·

Special Dividends: Special dividends are the paid either by companies that don’t pay a regular dividends or by companies that pay a regular dividends in addition to the regular dividends as one-time dividend. Such a dividends are usually paid in special circumstances such as when a company has a huge excess cash or makes the phenomenal earnings in a specific period. These are also called an irregular or extra dividends. Companies in a cyclical industries generally adopt this form of the dividends. They will pay less a regular dividends but will announce special dividends in the good times.

Liquidating Dividends: When the company goes out of a business and liquidates all its assets, it distributes a proceeds from liquidation to the shareholders in a form of liquidating dividends. Even when the company sells a portion of its assets and distributes a proceeds to shareholders, it’s known as a liquidating dividends.

Impact of Cash Dividends:

The payment of a cash dividends reduces the company’s cash, and thus its assets. It also reduces a market value of the shares by an equivalent amount. Therefore, when company pays cash dividends, a market value of its stock will drop. For example, if a current stock price is a $20, and a dividend of $1 is paid, then stock price immediately after the dividend payment will be $19.

Impact on Financial Ratios:

The decrease in a cash and assets will have following impact on a financial ratios:

  • Liquidity ratios will decrease.
  • Debt-to-asset ratio will increase.
  • Debt-to equity ratio will increase.

Stock Dividends:

Stock dividends are dividends paid in a form of new stock rather than cash. This is also known as a bonus issue of shares. In general, companies pay 2-10% of stock dividends on a total shares outstanding.Here are few important points about a stock dividends:

  • The total number of a shares for every shareholder increases.
  • The company does not have to spend any extra cash to the issue dividends.
  • Stock dividends are not be taxable, because there is a no change in the shareholder value.
  • Stock dividends don’t change an ownership structure.
  • Stock dividends don’t affect a shareholder’s wealth but a price of each stock reduces.
  • Stock dividends are more commonly used in a China.
  • Stock dividends do not affect the liquidity or financial leverage ratios because they don’t affect assets or equity.
Dividend Policy

Dividend Payment Dates:

Declaration date: The company’s board of authorizes the dividend payment and it is be announced. On this date, a company will also announce a record date and an actual payment date for a dividend.

Ex-dividend date: Also called an ex-date, it is a date from which the stock starts trading without a dividend. So, any investor who purchases a stock on or after ex-date will do so at a post-dividend price. Any investor who owns a stock before this date will receive dividends. In most global markets, an ex-dividend date is set two days before a record date. This is done to adjust for a settlement cycle, which is a T+3. In markets like a Hong Kong Stock Exchange an ex-date is one day before record date because they have a T+2 settlement cycle.

Record date: Also called the holder-of-record date, this is a date on which the shareholders with an ownership of a stock are designated to receive the dividend. This date is usually two days after ex-dividend date. This date is find by a company and is generally one week to the one month after declaration date.

Payment date: This date is also decided by a company and can fall on any date including the public holiday. The time between the record a date and payment date can vary from the few days to a month or more.

What is Dividend Policy?

Residual Dividend Policy: The term residual dividend refers to the method of calculating dividends. A dividend is a payment made by a company to its be shareholders. It is essentially portion of a company’s profits that is divided amongst people who own stock in a company.Various Dividend Models:

  • Dividend Relevance Model.
  • Traditional Model.
  • Walter Model.
  • Gordon Model.
  • Dividend Irrelevance Model.
  • Miller & Modigliani Position.

Traditional Models:

This model lays down the clear emphasis on the relationship between a dividends and the stock market. According to this model, a stock value responds positively to the higher dividends and negatively when there are a low dividends.This model establishes relationship between a market price and dividends using a multiplier.P/E ratios are directly related to a dividend payout ratios that is, a more dividend payout ratio will increase a P/E ratio and vice-versa.

  • P = m (D+E/3)
  • In which; P = market price
  • M = multiplier
  • D = Dividend per share
  • E = Earnings per share

Walter Model: The model studies a relevance of dividend policy in three situations:

  • r > Ke
  • r < Ke
  • r = Ke

According to Walter When r > Ke the firm has to an adopt a Zero% payout policy.

  • r < ke a firm has to adopt a100% payout policy.
  • r = ke any policy between the 0 to 100% payout.

Conclusion:

A dividend policy serves a purpose of guiding company on how and when to pay dividends to its an investors. This is important because studies show that a stakeholders are more likely to invest more in the company that pays dividends to its investors since paying a dividends is viewed as a sign of the company’s for good health.

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