When companies make profits, they share a proportion of those profits that they are generating during the period with their shareholders. These shared profits are called dividends. Most companies reward their shareholders through dividends. However, not all companies share the profits that they are generating with their shareholders.
Stock dividends come in different types. Investors looking for stable income can invest in dividend stocks. However, you must consider a few key points before investing in dividend stocks. You’ll need to consider the tax implications while evaluating returns in the form of dividends.
Investors must understand that dividends are not a legal obligation for the companies. A company making profits does not need to make a compulsory dividend payment to its shareholders.
Let us analyze these key factors around dividends.
What is a Stock Dividend?
A stock dividend is a share of profit that a company pays to its shareholders. Stockholders receive dividends in proportion to their shareholding in the company.
Usually, a company would announce dividends when it makes profits and has sufficient cash available. However, stable companies announce dividend payments even if they incur losses temporarily to satisfy their shareholders.
Most companies in the US pay dividends quarterly. Companies can pay dividends quarterly, semiannually, or annually to their shareholders. A dividend policy can change at any time and a company may discontinue the dividend program at any time.
How Do Stock Dividends Work?
When companies make profits, they can either retain them for reinvestments or distribute them to shareholders. Stable companies with established growth do not require to retain profits. They also need to satisfy their shareholders; hence they announce dividend programs.
Investors looking for regular income may invest in dividend stocks. These stocks usually have an established history of paying dividends to their shareholders. The dividend growth and payout ratio can change over time though.
Shareholders must be aware of three key dates with a dividend program.
A company’s board may take a vote on the dividend decision. After the decision is finalized, a dividend is declared. It is called the dividend declaration date.
The dividend program announces the payment date and an ex-dividend date. All shareholders holding the stock on or before the ex-dividend date become eligible for dividends.
Stockholders buying stocks after the ex-dividend date will not be entitled to dividends. However, existing shareholders selling stocks after declaration or ex-dividend date would still be entitled to dividends.
It is the date when stockholders on ex-dividend date would receive dividends.
Types of Stock Dividends
A company can decide on a dividend program or discontinue at any time. Usually, the executive board takes a vote to decide on the matter. A key consideration with dividends is the availability of free cash flow for the company.
If there is not sufficient cash available, a company may announce different types of dividends. Let us explore some key types of stock dividends.
These are cash payments that shareholders receive in their brokerage accounts directly. Cash dividends as we know are the most common type of stock dividends.
These dividends are paid to preferred stockholders. Generally, preferred dividends are paid at a fixed rate.
Special or Bonus Dividends
These are one-time cash dividends often paid as a bonus to existing shareholders. Often, these are announced when companies accumulate high profits.
Sometimes companies announce dividends in the form of stocks rather than cash. These stocks are also paid in proportion to existing shareholders like cash dividends.
Dividend Reinvestment Program
Companies offer dividend reinvestment programs. Shareholders can reinvest any dividends back into the company’s stocks.
Which Companies Pay Dividends?
Companies with stable growth and fewer needs for expansion often pay dividends. Dividends are paid out of profits but companies require sufficient free cash flow to fund the program. Thus, a company with sufficient cash and profits is more likely to announce a dividend for its shareholders.
Some companies with large accumulated profits may incur temporary losses. For reputational stakes, these companies may still continue their dividend programs. These companies often seek financing options to fund dividends or offer stock dividends instead of cash.
Growing companies with large profits and cash flow may not announce dividends as they prefer to retain profits for growth projects. Dividends are not a legal obligation for companies either. Thus, investors must carefully evaluate the historic dividend program.
Evaluating Stock Dividends – Dividend Ratios
Investors can evaluate and compare a company’s dividend program with others. Investors can use several tools to evaluate a company’s stock and dividend performance. Using dividend ratios is an important method for dividend evaluations.
Dividend Per Share
It depends on the number of outstanding ordinary shares and the amount announced for dividends. It is calculated simply by dividing the dividend amount by the number of outstanding ordinary shares.
It is calculated by dividing the DPS by the market price of the share. It is expressed in percentage terms. A change in the yield can be due to a change in either DPS or share price.
It is the proportion of profits that a company distributes to shareholders in the form of dividends. It is calculated by dividing the DPS by the EPS.
Free Cash Flow to Equity
Investors often analyze the free cash flows available for a company. Investors consider companies paying out dividends out of free cash flows a safer investment. Free cash flows are calculated by deducting debt payments, interest, taxes, and net working capital. The FCF is then divided by Equity to get the FCFE ratio.
Special Considerations with Stock Dividends
As we discussed above not all companies announce dividends programs. A company can also discontinue a dividend program at any time. Thus, investors must carefully consider these factors before investing in dividend stocks.
Let us discuss some key factors that affect the return on investment of dividend stocks.
Dividend growth is important for several reasons. It must cover the annual inflation rate at least which translates to around 3% in the US. A stable and consistent dividend that also has potential for regular growth is the most preferred choice for investors.
Dividend stability can be seen in several ways. For instance, a company continuing with a dividend program and keeping the same DPS is considered stable. Also, a company with accumulated profits is more likely to announce a dividend than loss-making entities.
These are the stocks that perform well in economic cycles. Some companies follow cyclic economic trends and yield different profits at different times. These stocks may pose a higher risk for investors than a stable and consistent growth stock.
Mutual Funds and ETFs have become a popular choice for investors recently. Investors can look for these funds that own a portfolio containing dividend stocks. These funds then share the dividend or reinvest them for investors.
As an investor, you must carry out thorough stock research to evaluate its dividend program. Several factors contribute to the final decision. You can look to reinvest the dividends to accumulate capital gains or use them as a steady income tool.
Stock dividends are important for investors looking for steady income. Investors must carefully evaluate dividend programs through ratio analysis. Several factors contribute towards the dividend decision of a company including profits, free cash flows, and growth opportunities for the company.