What are dividends?
Dividends are funds generated by profitable operations that are distributed directly to share owners, typically just after the end of a financial reporting period.
After a profitable period, a company can (at the discretion of its board of directors) pay some of its income to shareholders as dividends, and keep the remainder as retained earnings. Note that either action (declaring dividends or retaining earnings) meets the textbook definition of a profit-making company's highest objective: increase owner value.
This article defines and explains dividend, with examples, in the context of related dividend payment and dividend investing terms.
- What are dividends?
- Why and when do companies declare and pay dividends?
- Who decides whether to pay or not pay dividends?
- How frequently are dividends paid? Can there be preferential treament for some classes of shareholders?
- Do shareholders pay taxes on dividends recieved?
- What is the primary dividend metric? How is dividend yield defined and calculated?
- What are other metrics for comparing different dividend investments?
- How are dividends reported? How are dividend actions accounted for?
- Example Statement of Retained Earnings, with dividends.
Why and when do companies declare and pay dividends?
Who decides whether to pay or not pay dividends?
When a reporting period ends with a profit, the company can choose `to pay some of its income to shareholders, as dividends and keep the remaining income as retained earnings. Dividends are usually paid as cash, although companies occasionally pay dividends as shares of stock or even other kinds of property sent to existing shareholders.
Companies are not required to issue dividends—they may instead choose to channel all income from a reporting period to a retained earnings account (a balance sheet owner's equity account).
- Between 2005 and 2012, for instance, Apple, Inc. (based in the United States, stock symbol AAPL) did not pay dividends on its common stock, despite record earnings growth during that period. For the fiscal year ended 24 September 2011, Apple reported a net income of about US $26 billion, of which $0 were declared for dividends.
It is not unusual in fact for "technology" and other "high growth" companies to channel all earnings into balance sheet equity by skipping dividends. Their Boards presume that the company's stock is still attractive absent dividend payment, and share prices will grow, due to growing book value of the company and the promise of continued earnings growth. On the other hand, companies that prefer to attract shareholders who buy and hold their stock as a steady source of income do pay dividends.
- IBM Corporation, (based in the United States, stock symbol IBM) has paid quarterly dividends regularly since 1967. For the fiscal year ended 31 December 2011, IBM's reported net income after taxes was about US $15.86 billion. Of this, IBM's Board declared $3.47 billion to be paid as shareholder dividends.
The decision to skip or pay dividends, and how much to pay, is always the responsibility of the Board of Directors, although some Boards may be simply endorsing the recommendations of corporate officers and other senior management.
Note that quarterly or annual corporate financial results are always announced publicly after a reporting period ends—usually several weeks afterwards. Important dates regarding dividends follow:
- Declaration date: The Board of Directors may announce a decision on dividend payments when financial results are declared, or they may announce dividends shortly afterwards. In any case, the day that dividends are announced is the declaration date. The Board's declaration on this date creates a legal obligation to pay dividends (which shows up immediately in a "Dividends payable" account, a liability account).
- Date of record: On the declaration date, boards typically also announce a date of record, an ex-dividend date, and a pay date. Those who are registered with the company as share owners on the date of record will receive dividends. Those not registered as shareholders on the date of record do not receive dividends.
- Ex-dividend date: Closely related to the date of record is the declared ex-dividend date. The ex-dividend date typically comes two or more business days before
the date of record. Shares bought on or after the ex-dividend rate do
not come with the right to receive dividend payments even though they
may be bought slightly before the date of record. That is, those
who buy shares on or after the ex-dividend date will not be registered
with the company as dividend-receiving owners in time for the
immediately forthcoming date of record.
The ex-dividend date is the critical dividend-related date for investors because share price normally falls on ex-dividend date by an amount about equal to the per-share dividend.
The trading day before the ex-dividend date is sometimes called the in-dividend date. Shares traded on the in-dividend date are called in-dividend shares or cum dividend shares, meaning they are "with dividend."
Shares traded on or after the ex-dividend date are said to be ex-dividend shares. They are typically priced lower than they were earlier as cum dividend shares.
- Pay date: On the declaration date, boards also announce a pay date for the dividend (also called a payment date, or distribution date). This is the date those who were registered owners on the date of record actually receive payment.
For example, for the fiscal quarter and year ended 31 December 2011, IBM announced financial results. The important dividend related dates for IBM shareholders were:
Financial results announced: 19 January 2012
Declaration date: 31 January 2012
Ex-Dividend date: 8 February 2012
Date of record: 10 February 2012 ( 2 days after ex-dividend date)
Pay date: 10 March 2012
As expected, IBM's share price fell by the end of ex-dividend date, but not by the full value of the declared dividend ($0.75/share), On 7 February (in-dividend date) IBM shares closed at $193.35. A day later (ex-dividend date) IBM shares closed $0.40 lower, at $192.95.
How frequently are dividends paid? Can there be preferential treatment for some classes of shareholders?
Dividend declaration, payment amount, and payment timing are completely at the discretion of the company's board of directors—except for one requirement: If the board is not willing or able to pay dividends on all shares: they are required to pay dividends on preferred shares before paying dividends on common stock shares. Preferred share dividends, in other words, have preference over common share dividends.
Some companies issue a special class of preferred shares, called Participating dividend shares. "Ordinary" preferred shares may come with a stated dividend to be paid regularly, but participating dividend shares also come with a stipulation that shareholders receive additional dividend funds under certain conditions. That usually means the extra payment is triggered when the common share dividend rises above the stated preferred share dividend.
In some companies, moreover, preferred shares carry cumulative dividend rights. These rights apply to situations where the Board declares dividends but does not pay them in the current reporting period or before the next dividend declaration date. Once preferred share dividends are declared, the company is legally required to pay them before paying any common share dividends, even if payment has have to wait until a future period to pay. Dividends that have been declared but not yet paid are called dividends in arrears.
Dividends may in fact be declared and paid at any time, with any frequency chosen by the company's Board. However, most dividend-paying public companies (companies that sell shares of stock to the public) declare and pay regularly on a quarterly, semi-annual, or annual basis. As of early 2012, for instance, IBM has declared and paid dividends consistently on a quarterly basis since 1967. Ericsson (based in Sweden, stock symbol ERIC) has paid dividends consistently on an annual basis since 2005.
Besides regular period dividend payments, companies may also declare and pay a special dividend at any time. The stock market may in fact expect a special dividend when a company has extraordinary gains (e.g., through a substantial sale of assets), or substantial gains in operating profit. Such expectations can impact stock prices: For instance, as of Late 2011, Wynn Resorts Ltd. (based in the United States, stock symbol WYNN) had declared and paid special dividends in each of the previous 4 years. Expectations of another special dividend in 2011 were credited as the main reason for a 25% increase in Wynn share price during 2011. However, when Wynn announced financial results in October 2011, and made it clear that no special dividend would be forthcoming, the share price dropped immediately.
Do shareholders pay taxes on dividends received?
In most countries, shareholders must pay income taxes on dividends received. Many investors view this reality as an unfair form of double taxation. After all, the company itself is a tax-paying entity that has already paid income tax on its earnings before channeling the remaining (after tax) income into dividends or retained earnings.
In countries such as the United States and Canada, the apparent unfairness is partially—and only partially—mitigated by government regulations that tax individuals for dividend income at a rate lower than tax rates on other income.
Countries such as France, the United Kingdom,
Australia, and New Zealand arguably come closer to avoiding double
taxation through the process of imputation. This is a
way of giving shareholders (imputing to shareholders) credit for some or
all of the taxes already paid on the income in question. Under
imputation, dividend recipients receive imputation credits (or franking credits),
and their own tax liability for the dividend income is either lowered
or canceled completely (depending on the difference between the
corporate tax rate and the individual's own marginal income tax rate,
and also on the country's own imputation credit formulas).
Do investments in stock shares bring a good return on investment? Potential investors begin addressing such questions primarily by examining two sides of stock market investment analysis:
- Expected changes in share prices in the market.
- The expected timing and magnitudes of future dividend payments.
The two sides to the analysis are interrelated: whether or not a given dividend magnitude qualifies as a "good" return depends on share price, for instance. On the other hand, share price changes in the market depend on several factors, no doubt including expected dividend performance.
What is the primary devidend metric: How is dividend yield defined and calculated?
The basic investment metric for evaluating and comparing dividend performances from stocks is a ratio called dividend yield. The concept behind the metric is simple and readily understood: Dividend yield is obtained by dividing a year's total dividends by the share price. That is, the investor's returns (dividends) are compared directly to the cost of the investment (share price). Dividend yield is viewed by some as an instance of the cash flow financial metric return on investment (simple ROI).
Dividend yield is easy to explain but there is nevertheless room for confusion or misunderstanding with the concept. Consider the dividend yield formula:
Dividend Yield = (Total annual dividends per share) / (Current share price)
"Current share price" in the formula is sometimes called Prevailing share price. The interpretation of the formula is the same with either share price term, "Current" or "Prevailing."
Dividend yield is usually expressed as a percentage. For IBM's fiscal year ending 31 December 2011, the company paid four quarterly dividends, totaling $3.00 per share for the year. When the final quarter's dividends were declared in February 2012, the IBM share price was about $188. At the time IBM dividends were declared, therefore:
Dividend Yield = $3 / $188
This is the most frequently used dividend yield formula, sometimes more accurately called the formula for current dividend yield. Notice that the dividend total in the formula refers to a complete year's dividend payments, whereas the share price refers to one point in time, that is, the current value.
Of course, share prices can and usually do change every trading day, bringing a new dividend yield result with every change. It seems almost paradoxical that rising share prices--which increase the owner's potential value in the share investment--at the same time lower the measure of dividend performance. Because dividend yield may fluctuate from day to day and year to year, publishing analysts typically report a company's 5-year average dividend yield in addition to Current dividend yield.
Published dividend data may refer to Trailing dividend yield (or Trailing annual dividend yield), as an indicator that dividend yield is calculated from historical data—dividends paid in the preceding year. Analysts also publish their own estimates of Forward dividend yield (or Forward annual dividend yield), meaning the figure predicts for next year's dividend yield based on the current share price and the analysts predicted future dividend payments. That is, Current dividend yield ( or the equivalent Trailing dividend yield) is history, while Forward dividend yield is a forecast for the future that comes with some uncertainty.
Should dividend yield results be compared directly to ROI estimates for other kinds of potential investments? Some business analysts challenge the notion that dividend yield is truly a return on investment (ROI) metric, comparable to ROI figures from other kinds of investments. Simple return on investment, as applied in business and investment analysis generally, assumes that both the "returns" and the "investment costs" in the ROI formula represent actual cash flows. With dividend yield, however, "share price" in the formula has to be viewed as a hypothetical investor's opportunity cost for holding (for not selling) shares after collecting dividend payments. Opportunity cost is an important and real consideration in investment analysis, but it is not cash flow. That reality may or may not disqualify dividend yield as a true ROI metric, comparable to ROI results from other kinds of investments. Experts take different positions on that issue.
What are other metrics for comparing different dividend investments?
Potential investors seeking dividend income have many thousands of dividend-paying stocks to choose from. Naturally they have a keen interest in financial metrics that help compare and evaluate potential stock investments. When professional analysts are concerned especially with dividend performance, the metrics in the following two sections important.
Dividend payout is a measure of the Board's propensity for paying dividends from earned income. As such, the metric is helpful in estimating future dividend payments—if the company's overall financial performance and financial health remain strong (see the section below on Company Financial Metrics for Dividend Investors).
Dividend payout can be calculated from either of two formulas, both of which give the same result. The first and simplest approach requires (a) total dividends declared for the period, and (b) Reported net income for the same period.
[ 1 ] Dividend payout = Dividends declared / Net income
For example, for fiscal year 2011, IBM's reported net income of about $15.86 billion. For the same fiscal year, IBM's Board declared about $3.47 billion in dividends. From these data:
Dividend payout = $3.47 billion / $15.86 billion
The other formula for dividend payout uses the company's reported (a) dividends per share, and (b) earnings per share (EPS).
[ 2 ] Dividend payout = Dividends per share / Earnings per share
For fiscal year 2011, IBM reported earnings per share (EPS) of about $13.08 and total dividends per share of $3.00. Using these figures in the second dividend payout formula brings the same result:
Dividend payout = $3.00 / $13.08
Note that published and online EPS reports often use the label EPS (TTM), which indicates that the EPS figure is for the "Trailing twelve months" (preceding twelve months).
Some dividend investors consider a company's recent dividend payout history as an indicator of future dividend performance. Many prefer stocks with a consistent but relatively low dividend payout (less than 25%). A low payout now leaves room for dividend payout growth in the future.
For many dividend-paying companies, year-to-year dividend growth is regular and/or somewhat predictable. Trends in Dividend growth—like the two dividend metrics above—are good indicators of a company's future dividend payments if the financial performance and financial health are strong (see Company Financial Metrics for Dividend Investors below).
Dividend growth is usually measured as an average rate at which dividend payments change, year to year.
One year's dividend growth is simply:
1-Yr dividend growth = ( A - B) / B
Expressed as a percentage, where
A = Most recent year's total dividend per share
B = Previous year's total dividends paid per share
Exhibit 1, below, shows dividend growth information in graphical form.
Exhibit 1. IBM Dividends paid and annual dividend growth rates, 2000 - 2011. For the last 5 years of this period, annual dividends per share have grown at an average rate of 20.4%. This information will be useful for investors, for deciding whether to buy, hold, or sell IBM shares, or to invest in other dividend-paying stocks instead.
Company financial metrics for dividend investors
Dividends are declared and paid from earnings—net income after taxes. Dividends are declared and paid, moreover, by boards of directors concerned first with the company's long term survival and growth. As long as the company's financial performance and financial health are strong, generous dividend payouts may support their objectives for the company's capital structure. On the other hand, boards may reduce or skip dividends when performance and health need improvement, as signaled by poor earnings growth, a debt/equity balance that needs adjustment, inadequate working capital, or other warning signs. As a consequence, dividend investors will also pay close attention to traditional company financial metrics (or financial ratios) and their growth rates, such as
- Net income
- Earnings per share
- Return on equity
- Price to earnings ratio (P/E ratio)
- Debt to equity ratio
- Working Capital
Reporting and accounting for dividend Actions: Example Statement of Retained Earnings
For a profit making public company, the Board of Directors designates how income is distributed after each reporting period and this distribution is reported through the Statement of Retained Earnings. This statement shows how Income Statement profits from the period are either transferred to the balance sheet, as retained earnings, or to stockholders as dividends. The Statement of Retained Earnings thus serves as a bridge, or connecting link, between Balance Sheet and Income Statement.
The basic Statement of Retained Earnings equation is as follows:
Net income = Preferred stock dividends paid
+ Common stock dividends paid
+ Retained earnings
Retained earnings = Net income
– Preferred stock dividends paid
– Common stock dividends paid
Retained earnings, in other words, are the funds remaining from net income after dividends have been paid to the owners (shareholders). Note that dividend payments are not considered expenses and do not appear on the Income Statement. Dividend payments are not expenses because they are taken from net income, after all expenses have been subtracted from revenues.
Each period's retained earnings are added to the cumulative total
from previous periods, to create the current retained earnings balance.
This example Statement of Retained Earnings is from the same set of related company reporting statements used elsewhere in this encyclopedia, including an example Income Statement, Balance Sheet and Statement of Changes in Financial Position.
Example Statement of Retained Earnings with dividends.
By Marty Schmidt. Copyright © 2004-2016.