To get rich you have to be making money while you are asleep! Now, by this we mean, make an investment and let it be responsible for multiplying your money. If you are looking for a regular return on your investment? A dividend is a right option for you!
The dividend is a reward that companies extend to their existing shareholders ( a person, institution, or a company that owns at least one share of a company). The source of this reward is the company’s actual profit. The reward can be either in the form of cash (return on shares, buyback of shares) or equivalent shares.
Now, you must be thinking, why don’t companies reinvest the money in your business, why distribute the profit? Well, the foremost reason is that not often companies can invest their profits back into the business, secondly, the companies also have to think about the benefit of their shareholders from time to time. However, the company can opt not to share the entire profit, the rate of the dividend is actually decided by the board of directors of the company.
Does this all sound good news, well, there is a catch! There is no fixed period when a company releases dividends it can either be one time or can be paid at regular intervals like quarterly/ biannually/once a year differs from one company to another.
Dividend payments are not guaranteed since there are chances that management (board of directors) might cut or eliminate dividends during hard economic times. Also, a company’s stock value might be affected by the announcement of a dividend income declaration. Therefore management considers various parameters before issuing dividends to its shareholders.
But before we dive deep into understanding the deliverables of dividend let’s understand the types of it.
1) Preferred Dividend– Dividend which is issued to the preferred stock owners and accrues a fixed amount which is paid quarterly. This kind of dividend is generally given on shares that function more like bonds.
2) Special Dividend– It is generally issued under special circumstances when a company has accumulated substantial profits over years. These profits are looked at as access cash that does need to be used at a given point in time.
3) Stocks- Some companies offer stocks as dividends to their shareholders by issuing new shares. It is distributed on a pro-rata basis where the shareholders earn dividends depending on the number of shares he/she holds.
4) Assets- Apart from dividends, few companies may reward their shareholders with physical assets, securities, or real estate. However, this practice is very rare among companies.
5) Common stocks– It is paid to the common stockholders of a company from its accumulated profits. It is often decided by the law especially when the dividend has to be paid in cash and can lead to the company’s liquidation.
Since the dividend is paid on shares and only to existing shareholders, Let us also know how it impacts the value of the share price for the potential shareholders.
Though dividends to shareholders of the company do not influence the overall value of the business venture. But such a move tends to decrease the overall value of a company’s equity, the impact may be equivalent to the dividend paid. This means the amount that is paid as a dividend is debited from the accounts permanently and cannot be reversed.
There is also a domino effect to it, a company declares a dividend, and its share price increases due to the market activities, people are likely to purchase the share in hope of a premium.
But, the prices start to decline by a similar proportion once the dividend eligibility date expires. This is because new investors are not eligible to receive dividends and are hence reluctant to pay a premium price. Similarly, if the optimistic market is anticipated until an ex-dividend date, the value of the stock will increase as compared to the dividend offered. Such incidents often lead to an increase in the value of a company’s stock.
To understand the eligibility criteria It is very important that a shareholder becomes familiar with the important dates on dividends that are declared by the companies.
|Announcement dates||The date when the company’s management announces the dividend.|
|Ex-Dividend Date||The date when the dividend eligibility expires.|
|Record date||The date when a shareholder’s eligibility income is determined.|
|Payment Date||The date when the dividend amount is credited to shareholders’ account.|
How are the Dividend and Financial Modeling of the company related?
A dividend is not considered as an expense, because it is treated as an allocation of a company’s retained earnings. Since dividends tend to impact a company’s total equity thereby influencing the company’s financial modelling. Refer to the table below to know how dividends affect the different financial statements in the long run.
|Balance sheet||When a dividend is paid, It reduces liquid cash and also retained earnings|
|Cash flow statement||Dividends are reported as the use of cash under the finance activity header.|
|Statement of Retained earnings||A decrease in the value of retained earnings is reported.|
|Income statement||No impact|
You have now understood dividends and their impact on share value, but the paramount question is how is the Dividend amount calculated, isn’t it?
How is the Dividend calculated?
The dividend is calculated by using the method called Dividend Payout Ratio, The ratio can be expressed as
|Dividend Payout Ratio= Dividend paid/ Reported Net Income.|
Dividend paid refers to the amount that is paid to shareholders and Reported Net Income refers to the total net income of the company.
The dividend payout ratio is 0% for those companies where shareholders do not receive dividends. Also, the companies that pay the total income as dividends have a 0 dividend payout ratio.
The Dividend Payout Ratio helps to know the following things
– The amount that the company has to offer its shareholders.
– Total Amount that is reinvested for expansion.
– Company’s sustainability
A constant dividend payout ratio indicates a robust financial standing of the company.
You can also compute the Retention ratio by dividing dividend per share by earnings per share. The ratio can be expressed as-
|Retention Ratio = Dividend per share/ Earnings per share.|
The retention ratio helps to know the percentage of the amount that is kept by the company and not issued as dividends but credited as retained earnings in the accounts.
Some investors are also keen on calculating dividend yield on the share. Let us understand the difference and which is the best method for us!
Difference between Dividend Payout Ratio & Dividend yield?
A Dividend payout ratio indicates the company’s net earnings that are offered as dividends. Similarly, Company’s dividend yield indicates the rate of returns that were paid to shareholders. Therefore dividend payout ratio is considered to be more useful as compared to dividend yield as a small increase in the prices of shares will decrease the rate of dividend yield significantly. On the other hand dividend payout ratio helps to know the exact amount that has been paid to shareholders in a year.
Dividend Yield formulae are expressed as-
|Dividend yields- Annual dividends per share/ dividends per share.|
Hope you have now understood what the dividend is and how it is calculated. Investors that are looking to multiply their investment and receive high dividends should be thorough with the concept. Remember, successful investment is about managing risk not avoiding the gamble!
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