Chartered Financial Analyst (CFA) Investing

What are Dividends?

Dividends may seem rudimentary but there is more than meets the eye when it comes to this staple of the investment world.

A dividend is a way that a company can distribute earnings back to their shareholders.  These distributions are based on the number of shares owned, and the amount is approved by the company’s board of directors.  When looking for a company to invest in, many financial analysts look at several dividend related characteristics of a company, such as: historical dividend payment record, dividend payout ratio (dividend per share divided by earnings per share), dividend yield (annual dividends per share divided by share price), and the dividend growth rate.

Before being able to understand all of the dividend related metrics used in financial analysis, it is important to be familiar with dividends themselves, especially the different forms they come in.

The most general form of a dividend is a regular cash dividend, which is just a cash distribution paid to a company’s shareholders on a regular schedule, such as quarterly, semiannually, or annually.   Other types of dividends exist such as an extra or special dividend, which are just dividends paid by companies that do not pay dividends on a regular basis, or that are issued  when the company wants to distribute more cash back to their shareholders.  Companies that operate in cyclical industries tend to use special dividends as a means of distributing more earnings back to the shareholder.  For instance, car manufacturers may declare small regular dividends but when they have strong earnings they might declare a special dividend.

Some companies that issue regular cash dividends offer dividend reinvestment plans (DRP or DRIP) which automatically reinvests all or a portion of a cash dividend back into the company.  The company will then either purchase shares on the open market with this cash or issue new shares to fulfill plan.

So far this article has only discussed cash dividends, but more types exist: stock dividends are a form of non-cash dividends where the company distributes additional shares to its common shareholders.  There are several advantages of stock dividends:

  • Shareholders end up with more shares.
  • The company does not have to spend money on investment banks if they want to issue new shares, they can just declare a stock dividend.
  • More shares in the market broadens the shareholder base and keeps the stock price within an optimal trading range.
  • The company does not have to spend cash on a dividend which will decrease liquidity ratios.

Besides knowing the general background information of dividends, such as being able to differentiate a regular cash dividend and a special stock dividend, it is important to be able to understand several key dates regarding to dividends.

The first date on the dividend payment process timeline is the declaration date, which is the day that a company issues a statement declaring a dividend.  This statement includes what type of dividend will be issued, the amount, and when the record and payment date are.  The record date is a date which is determined by the company and is the date an investor must be holding the asset by in order to qualify to receive the dividend.  The payment date is the final date in the dividend process timeline and is the day the company actually makes the dividend payment to the shareholders, either by mailing a physical check or sending the funds electronically.  Unlike any of the other days mentioned, the payment date can occur on a weekend or holiday.

Another date that should be known is the ex-dividend date.  This is a day that is before the record date and is the first day a share trades without the dividend (ex-dividend means without the dividend).  If an analyst is looking at purchasing a stock to take advantage of its newly declared dividend, they must purchase the share before the ex-dividend date, or else they will not be the legal owner of it (due to stock settlement times) come record date.

On the ex-dividend date, the stock will open for the day trading at the previous day’s close minus the amount of the dividend.  For example, a share with a $0.50 dividend closes on Monday (the day before the ex dividend date) at $10.  On Tuesday (the ex date) the stock should open for trading at $9.50.

It is important to understand how dividends work and the process behind them.  Knowing the different kinds of dividends, such as whether it is a cash or stock dividend, regular or special, or if it is reinvested, is useful when analyzing companies. Also, being able to distinguish the dates will be helpful if you recognize an investment opportunity and want to take advantage of a recently issued dividend.

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