Dividends

What It Means

Dividends are the part of a business’s profit that is distributed to shareholders, individuals who own shares of stock in the company. The size of the dividend payment a business, or firm, owes to a shareholder is calculated by taking the accumulated earnings they choose to distribute and dividing that amount by the number of shares held by the shareholder.

Assume that in July 2003 Corporation A had 200 million shares of stock outstanding, meaning that 200 million shares had been issued (sold) and were owned by members of the public. If one individual owned 4,000 shares of Corporation A’s stock, then he or she owned 4,000 out of 200 million, which, calculated as a percentage, equals 0.002 percent of Corporation A. This means that this individual is, in essence, entitled to 0.002 percent of Corporation A’s profit.

Dividends are usually distributed to shareholders on a quarterly basis (every three months). In the United States companies generally pay their dividends in cash, but sometimes they pay them in stocks or bonds (additional shares in the company). A company’s ability to pay out dividends on a regular basis is often a strong signal to investors that the company is financially secure and likely to prosper in the future.

When Did It Begin

When a company is profitable and hence able to pay dividends to its shareholders on a regular basis, it can show both shareholders and the public how healthy and financially stable it is. In fact, in the early years of the twentieth century, when corporate practices were just developing, the ability of a company to pay dividends to its shareholders was one of the few ways it had to indicate how healthy it was.

After the stock market crash of 1929, Congress passed the Securities and Exchange Act (1934). As a result of this law, corporations were required to issue financial statements that explicitly showed their profits, debts, and other information. These statements allowed investors to make informed decisions about when, whether, and how much to invest in the company. Even with the development of this more transparent way of reporting company information, the dividend payment remains a reliable indicator for those who want to learn about and predict a company’s financial performance.

More Detailed Information

Most companies do not use their entire profit to pay out dividends to shareholders. A portion of the profit is typically kept in the category of retained earnings, to be used to strengthen the business with the purchase of property, hiring of personnel, or other investment. Technically, any shareholder of a profitable company is a part owner of these retained earnings as well, even if there is no immediate benefit to owning them.

When a company does not make a profit in a given quarter or year, it may choose to suspend (refrain from paying out) the dividend to its shareholders. It also may choose to continue paying them, but to do so it must use the retained earnings from previous quarters or years for the payments.

The board of directors of a company (a group of people that the shareholders have elected to represent them in company matters) is typically responsible for deciding how much and how often to issue dividends to shareholders. Sometimes the board will decide to pay no dividends because it believes that reinvesting all profits back into the company is the best way to serve the shareholders. If all profits are reinvested in the company, it is likely that future profits will be even higher.

When a corporation reinvests its profits, it has the chance to develop new products or even buy other companies. If the company spends its money well, it can increase its profits and, as a result, increase its dividends. For example, the computer giant Microsoft Corporation, a company that grew rapidly during the 1990s, only occasionally paid dividends to shareholders during those years. It was able to sustain its expansion partly because of this practice of reinvesting profits into the company. This decision to reinvest is typical of companies during their high-growth phases. After a company matures out of the time during which it would substantially benefit from reinvesting profits, it begins to pay dividends to shareholders.

Companies can issue different types of stock. The type of stock a shareholder owns has an influence on the type of dividends he or she can expect. Preferred stock is stock with what is called “dividend priority” over another type of stock known as common stock. Preferred stock typically has a dividend rate that is a fixed percentage of the profit (as opposed to common stock, which has dividend rates that are determined each quarter by the company’s board of directors). Preferred stock has preference over common stock, and therefore its dividends are issued to shareholders before the remaining amount may be divided among the common shares.

Recent Trends

Over the last century investors have found that corporate stocks have generally been good places to invest money. On average, corporate stocks sustained an annual return rate of 15 percent. This means that the average $100 invested in the stock market on January 1, 1990, would have increased in value to $404.56 by the beginning of 2000. Over shorter periods of time, however, one cannot assume that stock prices will necessarily rise at all.

Microsoft is a good example of what a company can achieve by reinvesting its profits. Those investors who purchased shares of Microsoft stock in the 1990s were especially able to benefit from the company’s rapid expansion and its practice of reinvesting profits back into research and development for new products. By the middle of 2003 Microsoft’s shares had reached a total value of almost $300 billion, which gave its shareholders confidence that they would eventually profit from their investment; the company paid its first dividend in March 2003.