Dividends and stock repurchases are the two major ways that corporations can distribute cash to shareholders. Dividends may also be distributed in the form of stock (stock dividends and stock splits), scrip (a promise to pay at a future date), or property (typically commodities or goods from inventory). By law, dividends must be paid from profits; dividends may not be paid from a corporation's capital. This law, which is designed to protect the corporation's creditors, is known as the impairment of capital rule. The law stipulates that dividend payments may not exceed the corporation's retained earnings as shown on its balance sheet.
Companies usually pay dividends on a quarterly basis. When the company is about to pay a dividend, the company's board of directors makes a dividend announcement that includes the amount of the dividend, the date of record, and the date of payment. The date on which the dividend announcement is made is known as the declaration date.
The date of record is significant for the company's shareholders. All shareholders on the date of record are entitled to receive the dividend. The ex-dividend date is the first day on which the stock is traded without the right to receive the declared dividend. All shares traded before the ex-dividend date are bought and sold with rights to receive the dividend (also known as the cum dividend). Since it usually takes a few business days to settle a stock transaction, the ex-dividend date is usually a few business days before the record date. On the ex-dividend date the trading price of the stock usually falls to account for the fact that the seller rather than the purchaser is entitled to the declared dividend.
Corporate dividend policy is a sometimes under-appreciated element of overall company strategy and financial planning. "It's difficult to generalize about dividend policy because it is usually very company-specific or industry-specific, [but] some general observations are possible," wrote Frederic Escherich in Directors and Boards. "Dividend policy's most important uses are to: 1) return excess cash to shareholders; 2) effectively manage the company's cash needs and capital structure; and 3) credibly signal shareholders about future earnings prospects." Indeed, when a company puts together its dividend policy, it must decide whether to distribute a certain amount of earnings to the company's shareholders or retain those earnings for reinvestment. Dividend policy is influenced by a number of factors that include various legal constraints on declaring dividends (bond indentures, impairment of capital rule, availability of cash, and penalty tax on accumulated earnings) as well as the nature of the company's investment opportunities and the effect of dividend policy on the cost of capital of common stock. Most firms have chosen to follow a dividend policy of issuing a stable or continuously increasing dividend. Relatively few firms issue a low regular dividend and declare special dividends when annual earnings are sufficient.
Opinions vary regarding the relationship between dividend policy and corporate taxation. "The usual argument is that since dividends are taxed as income, they have a tax disadvantage with respect to capital gains in a relatively light capital gains tax regime, especially for recipients in high tax brackets," wrote Francesca Cornelli in The Complete MBA Companion. "Therefore, other things being equal, companies that pay out high dividends should be valued less than companies that pay out low dividends. In response to this argument, however, economists have argued that the increasing domination of the market by tax-exempt institutions, the reduction of personal marginal income tax rates, the moves in both the UK and US to tax dividends and capital gains at the same rate and the abundance of tax shelters have all combined largely to neutralize the potential tax disadvantage of dividend payments."
see also Stocks
Allen, F., and R. Michaely. Dividend Policy. N. Holland Handbooks.
Cornelli, Francesca. "The Thinking Behind Dividends." The Complete MBA Companion. Pitman Publishing, 1997.
Escherich, Frederic A. "Deliberating on Dividend Policy." Directors and Boards. Fall 2000.
Lazo, Shirley A. "The Dividends of Dividends: How Significant are Boosts and Cuts?" Barron's. 1 July 1996.
Peskett, Roger. "Deciding Dividends." Accountancy. September 1999.
Hillstrom, Northern Lights
updated by Magee, ECDI
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.
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.
Dividends are a sum of money paid to stockholders out of a corporation's earnings. Once a dividend has been declared, the percentage of dividend that stockholders receive is based on a dollar amount per share of stock owned by the stockholder. Preferred stockholders generally have a prior right to dividend payments over common stockholders. Dividends are usually paid in cash. However, they can also be distributed in other forms: stock dividends and stock splits; scrip, which is a company's promise to pay in the future; or property, such as inventory goods. Most commonly, corporations declare dividends at regular intervals, such as monthly, quarterly, or annually. Before a dividend is paid, the board of directors must make a dividend announcement. This announcement sets the amount of the dividend, the date of record, and the payment date. The date of record is important as all stockholders have the right to receive the dividend on that date. By law, dividends can be paid only from corporate profits; they can not be paid from a corporation's capital. This measure, known as the impairment of capital rule, is intended to protect the corporation's creditors.
See also: Capital, Stock