A dividend is a distribution of a portion of a company’s earnings, decided by the board of directors, to a class of its shareholders. Dividends can be issued as cash payments, as shares of stock, or other property.
The dividend rate may be quoted in terms of the dollar amount each share receives (dividends per share, or DPS), or It can also be quoted in terms of a percent of the current market price, which is referred to as the dividend yield.
A company’s net profits can be allocated to shareholders via a dividend, or kept within the company as retained earnings. A company may also choose to use net profits to repurchase their own shares in the open markets in a share buyback. Dividends and share buy-backs do not change the fundamental value of a company’s shares. Dividend payments must be approved by the shareholders and may be structured as a one-time special dividend, or as an ongoing cash flow to owners and investors.
Mutual fund and ETF shareholders are often entitled to receive accrued dividends as well. Mutual funds pay out interest and dividend income received from their portfolio holdings as dividends to fund shareholders. In addition, realized capital gains from the portfolio’s trading activities are generally paid out (capital gains distribution) as a year-end dividend.
The dividend discount model, or Gordon growth model, relies on anticipated future dividend streams to value shares.
Companies That Issue Dividends
Start-ups and other high-growth companies such as those in the technology or biotechnology sectors rarely offer dividends because all of their profits are reinvested to help sustain higher-than-average growth and expansion. Larger, established companies tend to issue regular dividends as they seek to maximize shareholder wealth in ways aside from super-normal growth.
Companies in the following sectors and industries have among the highest historical dividend yields: basic materials, oil and gas, banks and financial, healthcare and pharmaceuticals, utilities, and REITS.
Arguments for Issuing Dividends
The bird-in-hand argument for dividend policy claims that investors are less certain of receiving future growth and capital gains from the reinvested retained earnings than they are of receiving current (and therefore certain) dividend payments. The main argument is that investors place a higher value on a dollar of current dividends that they are certain to receive than on a dollar of expected capital gains, even if they are theoretically equivalent.
In many countries, the income from dividends is treated at a more favorable tax rate than ordinary income. Investors seeking tax-advantaged cash flows may look to dividend-paying stocks in order to take advantage of potentially favorable taxation. The clientele effect suggests especially those investors and owners in high marginal tax brackets will choose dividend-paying stocks.
If a company has a long history of past dividend payments, reducing or eliminating the dividend amount may signal to investors that the company could be in trouble. An unexpected increase in the dividend rate might be a positive signal to the market.
Dividend Payout Policies
A company that issues dividends may choose the amount to pay out using a number of methods.
- Stable dividend policy: Even if corporate earnings are in flux, stable dividend policy focuses on maintaining a steady dividend payout.
- Target payout ratio: A stable dividend policy could target a long-run dividend-to-earnings ratio. The goal is to pay a stated percentage of earnings, but the share payout is given in a nominal dollar amount that adjusts to its target at the earnings baseline changes.
- Constant payout ratio: A company pays out a specific percentage of its earnings each year as dividends, and the amount of those dividends therefore vary directly with earnings.
- Residual dividend model: Dividends are based on earnings less funds the firm retains to finance the equity portion of its capital budget and any residual profits are then paid out to shareholders.
Economists Merton Miller and Franco Modigliani argued that a company’s dividend policy is irrelevant, and it has no effect on the price of a firm’s stock or its cost of capital. Assume, for example, that you are a stockholder of a firm and you don’t like its dividend policy. If the firm’s cash dividend is too big, you can just take the excess cash received and use it to buy more of the firm’s stock. If the cash dividend you received was too small, you can just sell a little bit of your existing stock in the firm to get the cash flow you want. In either case, the combination of the value of your investment in the firm and your cash in hand will be exactly the same. When they conclude that dividends are irrelevant, they mean that investors don’t care about the firm’s dividend policy since they can create their own synthetically.
It should be noted that the dividend irrelevance theory holds only in a perfect world with no taxes, no brokerage costs, and infinitely divisible shares.