Sunday, February 21, 2010


You have probably heard the phrase about something "paying dividends" meaning that something was succesful at what it set to achieve and is now generating tangible results but how is it applied when we are talking about stocks and the stock market? 

Dividends are payments from corporations to shareholders. When a company has a profit and generates cash there are basically two things it can do with that cash. It can pay it out to shareholders in the form of dividends or it can also invest it back into the business in the form of retained earnings, where it can use it to finance further growth or productivity. Most companies that pay out a dividend also have a portion of profits reinvested back into the business.

For us as investors or traders this means in simple terms that dividends are payments that we get just for being shareholders, just for holding the company’s shares. 

The way it works is as follows:

  • The company (its board of directors) declares a dividend 
  • It sets a date of record to indicate the date that it will use to verify its books and determine all the shareholders to whom it will pay out a dividend.
  • It also sets an ex-dividend date which is the first day on which holding the shares does not entitle the shareholder to the above-referenced dividend. If you want to receive the dividend that means that you should hold the shares as of the end of day of the day prior to the ex-dividend date. This will give your broker an opportunity to update the company’s records with you as a shareholder (the ex-dividend date is normally 2 business days before the record date because most companies’ shareholder records are updated 3 business days after you actually purchase your shares).
  • It finally sets the payment date which is the date when the dividend will be paid.
Now, there are many questions you might be asking yourself about dividends:

How often are dividends paid out?
Regular dividends are paid out once every quarter so four times a year.

Who determines the amount of the dividend to be paid out?
The company’s board of directors

Do all companies paid dividends?
Not all companies pay dividends. Dividends are a way for corporations to reward shareholders by distributing some of the profits that the business made. If the board of directors feels that that money is better put to use by reinvesting it into the business it might elect to pay out no dividend and use that money to finance growth. 

How does it benefit me as a shareholder if the company pays no dividend?
If the company pays no dividend that means that it now has more cash available to finance further growth which in theory will eventually be reflected in earnings growth and a higher share price (assuming P/E multiples remain constant).

What are the tax implications of dividends?
Dividends are considered income for the shareholder and are therefore subject to taxes (depending in your jurisdiction and specific circumstances). In most countries dividend income is taxed at a lower rate than regular income for the taxpayer and sometimes also lower than the capital gains tax rate. This is primarily because the money that is used to pay out the dividend has already been taxed when it was earned by the corporation at the corporate rate. In case you are wondering, yes, dividends are subjected to double taxation and that is another reason why some companies elect not to pay out a dividend since reinvesting that money back into the business is a way to avoid the dividends tax (the shareholder would pay taxes only at the time of selling if there is a capital gain).

Can a company that pays a dividend suddenly reduce it or stop paying one altogether?
Yes, but companies usually try to avoid this because it would be seen by the market as a sign of weakness, thereby in all likelihood it would impact the company’s stock price. If there is any modification to a dividend (increase, decrease, cancellation or implementation) it would need to be a decision made by the board of directors. For the most part though, companies tend to be very consistent with their dividends and some even increase them with regularity. 

What is a dividend yield?
The dividend yield is a ratio of how much a company pays out in dividends in a year compared to its stock price. It is therefore equal to Dividends/Stock Price normally expressed in percentages. This is a very important component of the analysis done when valuing a stock.

When I see the amount that a company pays out in dividends per share. Is that what I am going to receive on the next payment date?
The amount you see in dividends is normally expressed in annual terms so in the next quarterly dividend payment you will receive one quarter of that amount. For example, if a company's dividend is stated as $1.20 per share, that means that it will pay out the dividend in four even payments a year of $0.30 per share each.

What do I need in order to be paid a dividend?
To hold shares in a dividend-paying company by the end of day prior to a company’s ex-dividend date.

Couldn’t I just buy the shares right before the ex-dividend date and then get paid the dividend and sell them?
You could, but the market will price in that the company paid out a dividend and normally by the open of trading on the ex-dividend date the stock price will decrease roughly by the amount of the dividend so you will end with cash plus the value of your shares that roughly equals the stock price you paid prior to the dividend being paid out, only you now must pay taxes on the dividend that you just received.

What are one-time or special dividends?
Sometimes companies set one-time or special dividends to return capital to shareholders. Said capital could be in the form of cash but need not be so, it could also be in the form of shares or more rarely in some other form. One-time or special dividends happen quite often when there are spin-offs or spin-outs and those follow particular rules in terms of dates and also the taxation rules for it (there are some dividends that are non-taxable for example for spin-offs, especially if it is stock being distributed as dividend instead of cash)

For us as traders or investors it is important to understand what a dividend means and what it is telling you about the company. Normally, companies that are just starting out prefer not to pay a dividend and elect to reinvest any profits back into the business as it is going to lead to their growth. When a company matures and its rate of growth has stabilized companies implement dividends as a sign of consistency in the profits that they expect to make but also as a sign that perhaps it is a better use of capital to return it to shareholders rather than to invest it in the business. 

This is important for us to determine as dividend-paying companies in general are seen as more of value plays than growth plays. Stocks that are considered “value” stocks normally aren’t as volatile as their “growth” counterparts but this works on the downside (i.e. they hold up well in down markets) but also on the upside (their stock price doesn’t grow as fast as the stock price of “growth” companies). In other words, stocks that pay out a dividend are seen as conservative and a staple of investors looking for more safety and the cushion that the dividend offers (since it offers an income stream). Stocks that don’t pay out a dividend are seen as more volatile and therefore usually command higher P/E multiples so those are the stocks that are favored by traders since they are more volatile and are therefore more likely to offer trading opportunities.

Here are the dividend yields for the 30 stocks that make up the Dow Jones Industrian Index. These companies are seen as large, established companies with substantial market share in their market and it is reflected in the dividends that they pay out.