Dividends

About the name "dividends"

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.

What are dividends?

Dividends are just like a small reward a company pays you for owning shares of its stock. The company takes a portion of its earnings, which it divides and distributes to shareholders. In general, a company that has a slow growth rate pays high dividends. On the other hand, a company with a high growth rate usually pays no dividends. Historically, large corporations and utility stocks have paid regular dividends. These companies usually have growth rates of less than 10% and slow stock price appreciation but have high cash flow. They can pay dividends to investors attracted to income. In contrast, large corporations such as Google and Cisco have growth rates around 30% and high stock appreciation but do not pay dividends. Instead, they reinvest the earnings into the company in order to make the business grow.

What is dividend policy?

Once a company makes a profit, they must decide on what to do with those profits. They could continue to retain the profits within the company, or they could pay out the profits to the owners of the firm in the form of dividends. Once the company decides on whether to pay dividends, they may establish a somewhat permanent dividend policy, which may in turn impact on investors and perceptions of the company in the financial markets. What they decide depends on the situation of the company now and in the future. It also depends on the preferences of investors and potential investors.

How are dividends paid?

The Board of Directors of a company decides if it will declare a dividend, how often it will declare it, and the dates associated with the dividend. Quarterly payment of dividends is very common, annually or semiannually are less common, and many companies don't pay dividends at all. Other companies from time to time will declare an extra or special dividend. Microsoft gave out a one time $3 per share dividend last year. The total payout, which was made on December 2, 2004, was about $32 billion. Mutual funds sometimes declare a year-end dividend and maybe one or more other dividends.

If the Board declares a dividend, it will announce that the dividend (of a set amount) will be paid to shareholders of record as of the record date and will be paid or distributed on the distribution date (sometimes called the Payable Date). In order to be a shareholder of record on the record date you must own the shares on that date (when the books close for that day). Since virtually all stock trades by brokers on exchanges are settled in 3 (business) days, you must buy the shares at least 3 days before the record date in order to be the shareholder of record on the record date. So the (record date - 3 days) is the day that the shareholder of record needs to own the stock to collect the dividend. He can sell it the very next day and still get the dividend.

Can you predict the dividend before it is declared?

Many companies declare regular dividends every quarter, so if you look at the last dividend paid, you can guess the next dividend will be the same. Exception: when the Board of IBM or PG&E, for example, announces it can no longer guarantee to maintain the dividend, you might well expect the dividend to drop, drastically, next quarter. The financial listings in the newspapers show the expected annual dividend, and other listings show the dividends declared by Boards of directors the previous day, along with their dates. Other companies declare less regular dividends, so try to look at how well the company seems to be doing. Companies, whose shares trade as ADRs (American Depositary Receipts) are very dependent on currency market fluctuations, so will pay different amounts from time to time. Some companies may be temporarily prohibited from paying dividends on their common stock, usually because they have missed payments on their bonds and/or preferred stock.

Different dividend paying methods

Residual--Companies using the residual dividend policy choose to rely on internally generated equity to finance any new projects. As a result, dividend payments can come out of the residual or leftover equity only after all project capital requirements are met. These company's usually attempt to maintain balance in their debt/equity ratios before making any dividend distributions, which demonstrates that such a company decides upon dividends only if there is enough money leftover after all operating and expansion expenses are met. For example, let's suppose that a company named CBC has recently earned $1,000 and has a strict policy to maintain a debt/equity ratio of 0.5 (one part debt to every two parts of equity). Now, say this company had a project with a capital requirement of $900. In order to maintain the debt/equity ratio of 0.5, CBC would have to pay 1/3 by using debt ($300) and 2/3 ($600) by using equity. In other words the company would have to borrow $300 and use $600 of its equity to maintain the 0.5 ratio, leaving a residual amount of $400 ($1,000-$600) for dividends. On the other hand, if the project had a capital requirement of $1,500, the debt requirement would be $500 and the equity requirement would be $1,000, leaving zero ($1,000-$1,000) for dividends. Should any project require an equity portion that is greater than the company's available levels, the company would issue new stock.

Stability--The fluctuation of dividends created by the residual policy significantly contrasts the certainty of the dividend stability policy. With the stability policy, companies may choose a cyclical policy that sets dividends at a fixed fraction of quarterly earnings, or they may choose a stable policy whereby quarterly dividends are set at a fraction of yearly earnings. In either case, the aim of the dividend