Dividend

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This article is about the sharing of profits. For the mathematical sense, see Division (mathematics).

A dividend is the distribution or sharing of parts of profits to a company's shareholders.

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Purpose

The primary purpose of any business is to create profit for its owners, and the dividend is the most important way the business fulfills this mission. When a company earns a profit, some of this money is typically reinvested in the business and called retained earnings, and some of it can be paid to its shareholders as a dividend. Paying dividends reduces the amount of cash available to the business, but the distribution of profit to the owners is, after all, the purpose of the business.

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Types

The methods of sharing profits are as follows:

  1. Cash dividends (most common) are those paid out in form of "real cash". It is a form of investment interest/income and are taxable in the year they are paid. It is the most common method of sharing corporate profits.
  2. Stock dividends or Scrip dividends (common) are those paid out in form of additional stock shares of the issuing corporation, or other corporation (eg its subsidiary corporation). They are usually issued in proportion to shares owned (eg for every 100 shares of stock owned, 5% stock dividend will yield 5 extra shares). This is very similar to a stock split in that it increases the total number of shares while lowering the price of each share and does not change the market capitalization.
  3. Property dividends or dividends in specie (Latin for "in kind") (rare) are those paid out in form of assets from the issuing corporation, or other corporation (eg its subsidiary corporation). Property dividends are usually paid in the form of products or services provided by the corporation. When paying property dividends, the corporation will often use securities of other companies owned by the issuer.

Dividends must be declared (i.e., approved) by a company’s Board of Directors each time they are paid. There are three important dates to remember regarding dividends.

Important dates to know

Declaration date: The declaration date is the day the Board of Director’s announces their intention to pay a dividend. On this day, the company creates a liability on its books; it now owes the money to the stockholders. On the declaration date, the Board will also announce a date of record and a payment date.

Date of record: Shareholders who properly registered their ownership on or before this date will receive the dividend. Shareholders who are not registered as of this date will not receive the dividend. Registration in most countries is essentially automatic for shares purchased before the ex-dividend date.

Ex-dividend date: Is set by the exchange where the stock is traded, several days (usually two) before the date of record, so that all trades made on previous dates can be properly settled and the shareholder list on the date of record will accurately reflect the current owners. Purchasers buying before the ex-dividend date will receive the dividend. The stock is said to trade cum dividend on these dates. Purchasers buying on the ex-dividend date or after will not receive the dividend. The stock trades ex-dividend on these dates.

Payment date: The date when the dividend checks will actually be mailed to the shareholders of a company.

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Dividend-reinvestment plans

Some companies have dividend reinvestment plans, or DRIPs. These plans allow shareholders to use dividends to systematically buy small amounts of stock often at no commission. In some cases the shareholder might not need to pay taxes on these re-invested dividends, but in most cases they do.

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Reasons why companies avoid paying cash dividends

Companies have often avoided paying cash dividends for several reasons:

  1. Management and the board may believe that the money is best re-invested into the company: research and development, capital investment, expansion, etc. Opponents of this reasoning, such as Benjamin Graham and David Dodd who complain about the practice in the classic 1934 reference Security Analysis, suggest that this is in effect management dictating to owners how to invest their money. Proponents suggest that a management eager to return profits to shareholders may have run out of good ideas for the future of the company.
  2. When dividends are paid, shareholders in many countries suffer from double taxation of those dividends: the company pays income tax to the government when it earns any income, and then when the dividend is paid, the individual shareholder pays income tax on the dividend payment. This is often used as justification for retaining earnings, or for performing a stock buyback, in which the company buys back stock, thereby increasing the value of the stock left outstanding. The shareholder will pay a tax on capital gains (which is often taxed at a lower rate than ordinary income) only when the shareholder chooses to sell the stock. If a holder of the stock chooses to not participate in the buyback, the price of the holder's shares should rise, but the tax on these gains is delayed until the actual sale of the shares. Certain types of specialized investment companies (such as a REIT in the U.S.) allow the shareholder to partially or fully avoid double taxation of dividends.

Microsoft is an example of a company who has historically been a proponent of retaining earnings; it did so from its IPO in 1986 until 2003, when it declared it would start paying dividends. By this point Microsoft had accumulated over US$43 billion in cash, and there had been increasing irritation from stockholders who believed this large pile of cash should lie in their hands and not in the company's. Originally, the official reason to amass this large sum was to create a reserve for Microsoft's legal battles; since then, Microsoft appears to have changed tactics such that the reserve is not as necessary.

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Franking Credits

In Australia and New Zealand, companies also forward franking credits to shareholders along with dividends. These franking credits represent the tax paid by the company upon its pre-tax profits. One dollar of company tax paid generates one franking credit. Companies can forward any proportion of franking up to a maximum amount that is calculated from the prevailing company tax rate: for each dollar of dividend paid, the maximum level of franking is the company tax rate divided by (1 - company tax rate). At the current 30% rate, this works out at 0.30 of a credit per 70 cents of dividend, or 42.857 cents per dollar of dividend. The shareholders who are able to use them offset these credits against their income tax bills at a rate of a dollar per credit, thereby effectively eliminating the double taxation of company profits. This system is called dividend imputation.

The UK's taxation system operates along similar lines: dividends come with an attached tax credit which ensures that double taxation does not take place.

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About the name "Dividend"

The name comes from the arithmetic operation of division: if a / b = c then a is the dividend, b the divisor, and c the quotient.

In the United States, credit unions generally use the term "dividends" to refer to interest payments they make to depositors. These are not dividends in the normal sense and are not taxed as such; they are just interest payments. Credit unions call them dividends since, as credit unions are owned by their members, interest payments are effectively payments to owners.

In the United Kingdom, consumer co-operative societies use the term "dividend" for profit-sharing payments to their members. Unlike joint stock company dividends, these payments are made in proportion to a members' spending with the co-operative society, not the number of shares they hold in it.

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See also

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External links

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