Chapter 1-5 Dividends
Investors seeking income in their long term investment portfolio often look to invest in stocks that pay dividends. Dividends are payments made to shareholders by a corporation, usually based on the company’s performance over a defined period of time. Quarterly, semiannual, and annual dividends are the most common time frames however “special” dividends have been known to be paid out from time to time. In any given quarter a corporation receives revenue on goods sold or services provided, and spends money on costs of goods sold, payroll expenses, capital expenditures, and other expenses required to successfully run a business. At the end of the quarter an earnings report is released and the corporation reveals whether or not a profit was earned in that quarter. Dividends represent the portion of corporate profits that are paid to stockholders after all other expenses have been taken care of. Preferred shares receive dividends before common stock in exchange for voting rights and are often the target for dividend driven investors. Dividends are taxed as investment income in the year in which they are received.
There are two main types of dividends that corporations pay to their shareholders- cash dividends and stock dividends. Cash dividends are the most common form of dividend payment and represent a cash payment from the corporation to the shareholder. This payment is made in direct proportion to the ownership stake the shareholder has in the company. A predetermined amount per share is distributed and shareholders receive that amount multiplied by the number of shares they hold. Paying a dividend usually results in a decrease in the price of the stock equal to the amount of the dividend and thus market capitalization (total value of the company in terms of shares outstanding * price per share) decreases.
The following example breaks down a typical cash dividend declaration and payment:
- Kellogg Company (K), a leader in dividend payments, declares it will be paying $159,975,000 in dividends for the quarter
- Kellogg has 395,000,000 shares outstanding therefore the dividend will be $0.405 per share; equal to ($159,975,000 / 395,000,000)
- You own 1,500 shares of K
- You will receive a $607.50 dividend payment this quarter; equal to (1,500 * $0.405)
The second main type of dividend is the stock dividend. Also known as a scrip dividend, stock dividends are dividends paid out in the form of shares of stock in the issuing company. In rare cases stock dividends are paid out as shares of stock in a subsidiary corporation. Stock dividends, like cash dividends, are paid out in proportion to the number of shares owned. The additional shares used in the dividend payment can either be newly issued (similar to a stock split, the number of shares increases while the price of the shares decreases) or treasury shares (common stock that a corporation has repurchased on the open market). In both cases the market capitalization remains constant.
The following example breaks down a typical stock dividend declaration and payment:
- Dell Computer (DELL) declares a 3.5% stock dividend
- You own 2,000 shares of DELL
- You will be issued an additional 70 shares; equal to (2,000 * .035)
- Your total holdings will now be 2,070 shares
There are four important dates to consider when investing in dividends. The first of these dates is the declaration date. The declaration date is the day on which the corporation’s Board of Directors publicly announces that it will pay a dividend. Declaration creates a fiscal liability, and money is now owed to shareholders. The second date of importance is the date of record. Shareholders that are officially registered on or before this date will receive the dividend, all others will not. This date, along with the payment date, is announced on the declaration date. The payment date is the actual day when checks are mailed or electronic transfers occur. Finally, the ex-dividend date is the day the trading begins “ex-dividend”, meaning the seller of the stock retains his or her right to the dividend. The ex-dividend date is two days before the record date for US securities. Buyers of the stock in question will not receive the dividend on or after the ex-dividend date.
Consider the following graphic illustrating these dates:
Dividend reinvestment is a very common use for dividends received by investors. Most dividend paying corporations have dividend reinvestment plans, commonly known as DRIPs, in place to alleviate this process. DRIPs are set up to automatically use dividend payments to purchase additional shares of the company’s stock in lieu of receiving a cash payment. In most cases this occurs without a commission and sometimes even at a slight discount to market value.
DRIPs allow investors to slowly build a position in a stock over a long period of time through the power of exponential growth. This works because cash dividends on a per share basis will purchase more and more shares of stock as the position grows.
Consider the following example that shows the accumulation of stock through a DRIP program in which the stock price increases 2% a quarter and the dividend increases 5 cents semiannually:
Notice how in this example the position increases from 2,000 shares to 2,257 without investing another dollar. Simply holding 2,000 shares over the same time would have yielded a position value of $124,337.43, significantly less than the DRIP total. Furthermore, purchasing 2,257 shares up front in an effort to match the overall return would have required $112,850 which is nearly a 13% premium over the initial investment.