Last Updated on May 24, 2022 by Anjali Chourasiya
Dividend, in true terms, enshrines the concept that says shareholders are part-owners of a company. Because by and large, through dividends, net profits earned by the company are shared with the shareholders. A dividend is a mode through which a company rewards its shareholders for keeping faith in the company.
Dividend is even a strategy in stock investments and long term planning, even retirement, where investors pick stocks that pay out high dividends in order to earn regular income. Let us dive deep into the subject and understand what is dividend and how it works.
Table of Contents
What is a dividend?
When a company earns profits, it has two options to utilize the proceeds – it may either reinvest the profits earned (which is the case with most companies in the early stages of their business cycle) or it can pay out the profits to its shareholders by issuing dividends.
Thus, dividend can be described as the reward paid by a company in cash or any other means to its shareholders out of the profits earned by the company.
Is dividend payout compulsory?
No, every publicly listed company holds the right to decide if it wants to pay a dividend or not. It’s not an obligation for the company. The board of directors of the company has the final say on the payment of dividends. A dividend is usually only one part of the profits earned by the company and does not account for the whole of it.
Companies can always skip dividends when they feel the need for cash and want to reinvest the earned profits in the business to further growth or chase new markets.
Traditionally, the IT sector has been a favourite when it comes to dividends. Market participants keenly observe the companies announcing dividends, and a fair share of fluctuations is experienced in the stock for which the dividend is announced.
Types of dividends
While some types of dividends are based on the mode of payment opted by the company, some result from some extraordinary circumstances. Let’s find out about each of them:
Cash: Most companies find paying a dividend as cash as the most feasible option. The dividend so declared is either electronically transferred or paid as a cheque.
Preferred: It is named so because of the class of shareholders it is paid to. This dividend is paid to preferred shareholders at a fixed rate.
Stocks: The dividend issuing company offers stocks to the shareholders in proportion to the shareholding of the existing shareholders. Though this is quite a lengthy procedure as the company’s share capital needs to be altered, it is less common in India to see companies paying stocks as dividends.
Assets: The payment of dividends is not limited to cash or shares. The company can pay it in kind also. The company can reward shareholders with physical assets of the company, its property, and investment securities too. Again it is not very common.
Special: A company may decide to make its shareholders a party to the extraordinary profits. By extraordinary, it means higher profit margins than management expectations. These profits can be accumulated over the years too, and when the company feels like there is no need to reinvest such huge cash, it pays it out to shareholders outside of its regular dividend policy.
How does the share price react to dividends?
To grab hold of dividends, market participants pay a premium price, and thus, one may observe that the share price is going up. However, when the dividend date expires, investors have no real motive to pay such a high premium, and thus, the share price may fall.
Even though the share price experiences a lot of fluctuations that cause a change in the market cap of companies, the same is not the case with enterprise value.
To understand this, let’s take up an example:
Suppose company A with equity of Rs. 100, a debt of Rs. 20 and cash of Rs. 10 in its balance sheet announces to pay a cash dividend of Rs. 2.
Let’s calculate the value of the business before and after the payment of the dividend.
- Before paying the dividend, the net value of the business comes out to be Rs. 110 ( equity + debt – cash).
- After paying the dividend, the reduced value of equity is Rs. 98, while the reduced value of cash is Rs. 8.
The value of the business comes out to be Rs. 110 (equity + debt – cash) in this case as well!
Important dates pertaining to dividends
Dividend announcement date
It’s the date on which a company declares a certain percentage of its post-tax profits as dividends. The dividend is expressed either in terms of rupee or percentage of the book value of shares of the company. However, to find out who is eligible to receive the dividend, we must know the record date.
Companies adopt a simple procedure of paying dividends to shareholders whose names appear on the shareholder’s list on the record date. For example, if a company finalizes 10 October as a record date, it will pay dividends to all those shareholders having their names in its shareholder records as of 10 October. However, one needs to be mindful that the Indian stock market follows the T+2 days delivery system, making the ex-dividend date a lot more important.
In the T+2 days delivery system, the delivery of shares is after two days. The names of investors do not appear in the company’s shareholder records unless they get the delivery of shares. Hence, to get the delivery by the record date and be eligible for dividend payment, one needs to buy shares before the ex-dividend date. The ex-dividend is generally fixed two days ahead of the record date for this purpose.
Dividend payment date
Those eligible for receiving the dividend receive the dividend either through bank mandate or physical delivery of cheques. The time frame for payment of dividends, however, depends on the type of dividend. If it is an interim dividend, the same is paid within 30 days from the dividend announcement. While if it’s a final dividend, the same will be paid within 30 days of the company’s annual general meeting.
Investors looking for a passive income on top of capital gains from their equity investments resort to dividend collection. Even though laws do not bind companies, they resort to paying dividends out of the net profits earned to foster the trust of their shareholders. Investors need to consider the fact that market forces often anticipate and react strongly to dividends.
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