What is a dividend?
A dividend is a payment of a part of the company’s profit to their shareholders. The objective of distributing revenues or a dividend to investors, is to attract new investors. The dividend can be considered a reward for people who dare to invest on the long-term by holding their shares. This article will tell you all about the impact of a dividend on your investments.
What is a dividend?
Publicly listed companies can decide to issue part of their profit to their shareholders. The dividend announcement often results in a proportional stock price increase while the actual dividend payments results in a share price decrease.
The rest of the article will provide you some more details on how a dividend influences your investments. Feel free to use the below overview to directly navigate to the appropriate chapter:
When a company decides to issue a dividend, it all starts with an announcement. The announcement is the moment a company announces the dividend ratio and on what date it will be issued; the payment date. The stock will rise in price by the value of the announced dividend. When a share is traded at $10 and a $1 dividend is issued, the share price increases by $1 too.
An important date next in line is the so-called ex-dividend date. The ex-dividend date is the moment at which it is determined who is entitled to receive a dividend. All people who own stocks of the company prior to the ex-dividend date, will receive the dividend. You are not entitled to receive a dividend if you buy a stock on or after the ex-dividend date.
On the ex-dividend date, the stock will drop in price by the value of the dividend. The stock value logically decreases: after all you will not receive any additional profit payment. When for example the stock price is $10 and the dividend is $1, the stock price will drop to $9.
The record date is the date on which the company determines who is entitled to receive a dividend. Shares are continuously changing owners and are a free-trade product. Therefore, the company needs to determine who is eligible to receive part of the profit. The record date is usually one business day after the ex-dividend date.
Would you like to be eligible to receive a dividend? In that case, you must buy the share at least two days before the record date.
The payment date is the date when dividend checks are credited to investors who are eligible to receive the dividend. When you have bought the share on the ex-dividend date or even later, you are not eligible to receive a dividend. It can take a month before the actual payment takes place (= the payment date).
It can be interesting to keep a close eye on the stock price on the payment date. The stock price may fall on the payment day when investors fear the company in fact cannot really miss the money.
A €3 dividend was paid on the HeadFirst Source G stock. On the ex-dividend date (24th of December) the stock logically dropped in price by €3.
Cash dividends are by far the most common dividend type. The company will pay part of the profits in cash. Let’s look at an example.
Imagine having 1000 stocks which value $10 per stock and therefore have an overall stock value of $10.000. If the dividend percentage equals 5%, you will be paid $500 cash dividend.
Sometimes a company can choose to distribute its profits by issuing shares. This payment option is also known as a stock dividend. Let’s look at an example.
Imagine having 1000 stocks which value $10 per stock and therefore have an overall stock value of $10.000. If the dividend percentage equals 5%, you will be paid $500 stock dividend. Considering a $10 stock price, you receive 50 new additional stocks.
Companies might have various underlying reasons to issue dividends. Below we discuss some reasons why companies can decide to distribute part of their profits by issuing a dividend.
Shareholders are co-owners of the company. As a reward to the investors who have decided to invest part of their money in the company to become co-owner, the company can decide to distribute part of its profits by issuing a dividend. This way, they reward their loyal shareholders for putting their confidence in the company.
Lack of interesting alternatives
A company can generate more profits in the future by investing their income in new projects. When a company has no plans to start new projects, the company can choose to distribute part of its profits to the shareholders.
When a company has consequently issued dividends, the elimination or decrease in the dividend amount can lead to fear. If a dividend amount reduces, the investors can suddenly start selling the stocks resulting in a stock price fall. A perfect example is the Shell dividend. Shell cut its dividend for the first time since World War II during the corona crisis in 2020 after which the stock price crashed.
Nevertheless, decreasing or completely removing the dividend isn’t automatically a bad omen. The company can also have started an interesting new project or investment which can generate even more profit in the future. It is therefore of crucial importance to thoroughly investigate the underlying reason of the dividend decrease.
For many companies frequently issuing a dividend is essential. Dividends attract investors and often even long-term ones. When no dividends are issued, investors can decide to sell their stocks resulting in a stock price decrease.
A company can use different strategies when paying out dividends. Below we discuss how a company’s management can determine how much dividend will be paid:
No fixed policy
When a company doesn’t have a fixed dividend policy, the management is free to determine when and if a dividend is issued. This strategy means less certainty for the shareholder. Stocks with a variable dividend policy might therefore fluctuate more compared to stocks with a fixed dividend policy.
Fixed percentage of profits dividend
Some companies pay out a fixed percentage of their profits as dividend. This approach offers the shareholders more freedom. On the other hand, there is always a risk the company will issue more dividend than appropriate. The percentage can also be on the low side for the shareholder.
Fixed or growing dividend
Choosing for a fixed dividend policy, there is no increasing dividend and the shareholders will receive the same payout, month after month and year after year. A dividend growth means the dividend will increase periodically. A clear risk is the fact there is never a 100% certainty the company will be able to live up to the shareholders’ expectations. When a company decides to issue less dividend, the stock price can drastically fall.
Be careful with dividend payments
Don’t be blinded by the dividend alone. When companies issue a dividend, it can have a negative impact on the company’s position. Do your research by for example using the payout ratio to determine whether a company is capable of issuing dividends.
Besides, it’s important to take into consideration how the company issues dividends. Sometimes companies issue new shares, which are then used to issue their dividend. Somehow it will lower the value of your company shares, and it could also lower your future return on investment.
Issuing dividends can also limit the growth of a company. The company has less money available to invest in the future and therefore risks becoming less competitive.
An alternative for issuing dividends, is purchasing stocks. Some companies use their profits to repurchase their own publicly listed stocks. It will result in the reduction of shares and logically also in the increase in earnings per share for the shareholder. The shareholder is granted a more favourable position.
The dividend amount differs from one company to another. Companies which have a mature status (have been around for a long time) and which make big, predictable profits are more likely to pay out profits. Examples of these types of companies include:
- Oil and gas companies
- Banks and financial institutions
- Pharmaceutical companies
- Utility companies
New start-ups and companies which experience a strong growth often issue no or little dividend. These companies often face high costs or even losses. Think about companies like Uber and Google. This type of companies prefers to invest their money in new projects and developments to create more future value for their shareholders.
As a shareholder, there are two ways to benefit from shares: by dividend and by stock price increases. When a company reinvests its profits in a smart way, it can benefit the profitability and overall growth of the company. In that case, nevertheless, it is important the return on new investments is higher than the return achieved by simply repurchasing the own stocks.
Utility companies often issue high dividends
Does a company always issue a dividend?
There are companies which will never issue a dividend. Some major companies do not see the necessity to issue a dividend, because their share price drastically increases year after year. Think about companies like Apple and Google. Therefore, investing in a stock which doesn’t issue a dividend can still prove to be profitable. A increasing stock price will also increase your return on investment!
Even companies which regularly issue a dividend, can decide to skip the dividend once. There might be various reasons for skipping a dividend or part of a dividend; think about new investments or for example an acquisition. In the long run this might lead to an even higher return on investment.
Being a shareholder, the dividend amount you receive also depends on the type of stock: preferred stocks or common stocks might have different dividend percentages.
By holding your stocks, dividend is another alternative to realize a profit. Even when the stock price is falling, a positive return on stock investment can still be made by receiving a dividend. Especially when investing in stocks in the long term (read several years), a dividend will help you to achieve a positive return on investment.
Investing in dividends is often a quite stable and less risky type of investment. Dividend investments are considered to be a relatively safe haven because many companies which issue a dividend have a stable basis and background. When you focus on dividends, the stock price is of minor importance. A perfect example of a stable stock which has been issuing dividends for years is the Shell stock. By investing in stocks with a fixed dividend payout, you can realize a stable stock income.
Companies normally clearly announce the date and time when a dividend will be issued. Based on these announcements online brokers can present clear overviews containing all dividend dates. Besides, there are handy online calendars which displays all dates on which dividends will be issued. A perfect example is the dividend calendar of thestreet.com.
The dividend calendar tells you when a dividend will be issued.
Most companies issue a dividend once a year. There are some companies though which also pay out interim profits. This is a part of the final to be determined dividend for the whole financial year. At the end of the financial year it is then determined how much dividend still had to be paid out. Companies can decide to issue a dividend quarterly or biannually.
You can consult the interim-dividend per period on the Shell website
Many investors use their dividend as an additional income: they for example use it to book their well-deserved holiday. Nevertheless, reinvesting your dividend might result in much better investment results in the long term. It all has to do with the wonderful mechanism of exponential growth. The one and only Einstein called compound interest the eight wonder of the world.
If you keep on reinvesting the dividend, you receive interest on the reinvested amount too. That’s what we also call interest-on-interest or compound interest. In the long-term compound interest can lead to major profits. Let’s take the below example whereby we invest $10.000 a year at an average interest rate of 8%.
- Upon 10 years of investing, we have invested $ 100,000 and we have $ 156,000 (X1,5).
- Upon 30 years of investing, we have invested $ 300,000 and we have gained $1.223.458 (X4).
- Upon 50 years of investing, we have invested $ 500,000 and we have gained $6.196.717 (X12).
It is pretty easy to calculate the dividend return on investment on a share. You just take the total market capitalization (the total value of the issued stocks) and you divide it by the total dividend.
Another way to calculate the dividend yield is by dividing the dividend per share by the price per share. When a share for example costs $10 and the return on investment is $1, you receive a dividend return of one percent.
Other dividend formulas
The dividend yield nevertheless is only part of the story. You should also consider the dividend payout ratio. The dividend payout ratio is calculated by dividing the dividend yield by the profit. This way you can determine how much of the profit the company pays out in dividends.
You can also try to find out how much of the free cash flow is paid out as a dividend. The free cash flow is the cash a company generates and can spend afterwards. The ratio is calculated by dividing the issued dividend by the free cash flow.
These formulas can help you to determine the security of a dividend payment. When companies take serious risks to satisfy their shareholders, it can have a negative effect on the company’s results in the long term.
The effects of a dividend on your mindset
A dividend can have a serious influence on the mindset of each investor. It will give a moral boost. When someone is continuously receiving dividend payments, it can boost their confidence in the company. Moreover, a dividend is a great protection against inflation.
You should take into account though that high dividend payouts endanger future growth of the dividend. High dividend payouts result in less available money for investing and consequently less growth, expansion, and innovation of the company.
Investment funds can also issue a dividend. When you invest in a fund or ETF, you become a fund participant. Being a participant, you become the owner of a part of the investments of the fund. The fund invests the money of all the participants in for example stock and bond baskets.
Some funds then distribute interest payments on bonds and dividends on stocks to those people who participate in the fund. This amount is then paid via a dividend. Other funds might choose to automatically reinvest the dividend. It is therefore of crucial importance to carefully read the general conditions of the fund to avoid future surprises.
Companies must adhere to certain rules and regulations when they decide to issue a dividend. The intention of a dividend is to distribute profit. It is therefore only permitted to distribute dividends from profit or profit reserves. A company is not allowed to issue a dividend from its mandatory legal reserves or from its capital.
Under certain circumstances a company is allowed to borrow money to issue a dividend. This process is possible when the company has sufficient reserves but insufficient cash. Keep this in mind though: the company will have to pay financing costs which might negatively affect the profitability of the company.
The shareholders have the decisive authority to determine the dividend. At the shareholders’ meeting, shareholders can therefore vote on the dividend policy.
What is the impact of an acquisition?
There are some special situations in which a dividend can play an important role. A company can for example decide to sell part of the company. In this case, the company will receive an acquisition price. This amount is then paid out as a dividend to the shareholders. Depending on what has been agreed, the shareholders will receive their dividend as cash dividend or as stock dividend.
The dividend history
The dividend is a Dutch invention. The first exchanges were established in the Netherlands; they were established in 1602 together with the establishment of the VOC (the Dutch East India Company). The VOC needed huge amounts of money to invest in their expensive expeditions all around the world. Therefore, they made a promise to their investors: the investors received shares in return, and they were promised a profit distribution on these shares. They paid over 18% of the value of the stocks. They followed this ‘dividend’ policy until 1800. In those days you would have achieved wonderful results by investing in VOC stocks!