Dividends: Meaning, Different Types and Impact on Stock

In the previous chapter, we’ve covered what bull and bear markets are, and saw that shift in investor sentiment plays a major role in causing these markets (here’s the link if you missed them!). In this chapter, we shall learn how major corporate actions like dividends impact a stock.

How would you react if your favourite brand announced a freebie on every purchase? Or a product you have been using is being removed from the market? These are smaller, closer examples of how company actions impact our emotions towards it. Let’s now look at the larger picture - any activity undertaken by the board of directors of a company that impacts the company and its shareholders is called a corporate action.  

The primary reason for companies to embark on corporate action is to build value for the company's shareholders. Unfortunately, corporate action is not always undertaken in a favourable condition. For instance, sharing profits with shareholders through dividends is great news that impacts the stock positively. However, that means less money for the company to invest in itself. On the other side, it is possible that the company is draining money and needs to be liquidated. Now, this is bad news as far as the stock market is concerned. 

In this module, let’s run through a few popular corporate actions and how they impact the company and the stock market. 

For the first chapter, let’s pick up the most common and possibly much-anticipated corporate action that even has shareholders creating investment strategies around it - Dividends.

What Are Dividends?

A dividend is a part of the company’s profits that the Board of Directors decides to share with the stockholders. Such remuneration can be in the form of money (cash), additional stocks or any other benefit.

Note that companies aren't obligated to pay dividends. It is a choice they make - to either pay out a dividend or reinvest the full profit to grow the business. 

Back in the 1600s, companies like the Dutch East India Company started sharing their profits with shareholders. This laid the foundation for the dividend system we know today. This practice gave investors a tangible return on their investment, playing a crucial role in retaining faith and funding in the company.

Nowadays, companies can choose when and how to hand out dividends. It could be every month, quarter, or year. For instance, companies like Vedanta Ltd and Hindustan Zinc routinely make quarterly or monthly dividend payments. It's a way these businesses show appreciation to those who invest in their journeys.

Dividends aren't just about sharing profits – they also give us an indication of whether a company is financially fit and optimistic about its own future. When companies regularly provide dividends, it makes investors happy not only for the extra they earn, but also because it shows stability and confidence from the people running the company.

Deciding to pay dividends is a balancing act. Companies need to think about how much money they should give to shareholders and how much they should keep for growing the business. It all depends on their overall plan, what's happening in their industry, and the current economic situation (Now you know what happens in those board meetings!). 

Important Dates in Dividends

• Announcement/Declaration Date:

This is when company management officially announces the dividend. It's also known as the declaration date.

• Record Date:

The Record Date is the cutoff date set by the company to determine which shareholders are eligible to receive the upcoming dividend. 

• Ex-Dividend Date:

If a stock has an ex-dividend date of, say, Monday, May 5, it means that starting that date, the stock does not carry the value of the amount set aside for dividend payments. The share price adjusts to reflect the dividend. Investors who buy the stock on or after ex-div. date won't be eligible to receive the upcoming dividend. The ex-dividend date is typically set one or two business days before the Record Date.

• Payment Date:

This is the day the company actually sends out the dividend payments.

Why Do Companies Issue Dividends?

The decision to pay dividends is a strategic move with far-reaching implications. Let's delve into the motives as to why companies choose to extend a financial handshake in the form of dividends.

• Acknowledging Shareholder Loyalty: 

Companies pay dividends as a tangible expression of gratitude to their loyal shareholders. 

• Building Investor Confidence: 

Companies that reliably distribute dividends often become perceived as financially robust and dependable, fostering confidence among shareholders.

• Capitalising on Surplus Cash: 

Rather than letting cash accumulate without purpose, distributing dividends allows companies to efficiently deploy excess funds and enhance shareholder value.

Several well-known companies, such as Coal India and ITC Ltd, are notable for paying dividends. 

It's worth noting that while paying dividends can be a positive signal, it's not the only factor to consider when evaluating a company's overall health and potential for growth. Investors typically assess a combination of financial metrics, business strategy, and market conditions to make informed investment decisions.

Why Do Some Companies Choose Not To Pay Dividends?

Companies may choose not to pay dividends for various reasons:

• Funding Growth and Operations:

Fast-growing companies, especially those in their early stages, may need to reinvest their earnings back into the business to fund operations

• Initiatives, Acquisitions, and Debt Repayment:

Companies may choose to reinvest their profits to fund new initiatives, acquire other businesses, or reduce debt. These activities can contribute to share price movement.

• Impact on Share Prices:

Reinvesting earnings rather than paying dividends can lead to a higher valuation for the company (perceived worth of the company) and, consequently, an increase in share prices. This can be advantageous for both the company and its investors.

• Tax Considerations:

Non-qualified dividends are taxed as ordinary income, subject to the investor's marginal tax rate, which can be as high as 37%. On the other hand, qualified dividends and long-term capital gains may qualify for lower tax rates, potentially making them more attractive to investors.

• Avoiding Costs of Issuing New Stock:

Companies may choose to reinvest earnings to avoid the potentially high costs associated with issuing new stock. By using retained earnings, companies can fund their operations without diluting the ownership stake of existing shareholders through the issuance of additional shares.

What Is Dividend Yield?

Dividend yield is a ratio (expressed as a percentage) that indicates how much money an investor is receiving for each rupee they invested in a stock. 

The relationship between stock price and dividend yield is inverse, meaning that as the stock price rises, the dividend yield decreases.

• Dividend Yield= (Dividend per Share/Stock Price per Share)×100
• For example:
• If ABC Corporation, purchased at ₹100 per share, pays an annual dividend of ₹10 per share, the dividend yield would be

(₹10/₹100)×100=10%

• If the stock price increases to ₹200 per share, the dividend yield drops to

(₹10/₹200)×100=5%

• The inverse relationship is evident: as the stock price rises, the dividend yield decreases.

Dividend Pay-Out Ratio:

The Dividend Payout Ratio is a financial metric that indicates the proportion of a company's earnings paid out to its shareholders in the form of dividends. It is expressed as a percentage and is calculated by dividing the total dividends by the net income of the company.

Dividend Payout Ratio=(Total Dividends/Net Income)*100

A high payout ratio may indicate that a significant portion of earnings is being distributed as dividends, leaving less for reinvestment or other uses. On the other hand, a low payout ratio may suggest that the company is retaining more earnings for growth opportunities or to cover potential future obligations.

In general, a balance in the Dividend Payout Ratio is sought, aligning with the company's overall financial strategy and growth objectives. Different industries and companies may have varying optimal payout ratios based on their specific circumstances and goals.

Types of Dividends

1. Cash Dividends

When a company issues a cash dividend, it is paying part of the profit earned to shareholders as money. 

Cash dividends are the most common type of dividends, paid out every month, on a quarterly basis or annually.

Companies that regularly share money with their shareholders are perceived to be well-established and doing well financially. They've gone past the early growth stages and are seen as stable.

How Cash Dividend Works?

Cash dividends can be given monthly, annually or every six months. Now, these cash dividends can be routine, just part of the company's usual way of saying thanks to its shareholders. 

It's the company's call on how they want to manage these cash gifts. And when it's time to distribute these dividends, it's done on a per-share basis. It's like a little reward for trusting in the company and investing in its journey.

When and How much of Cash Dividends?

When a company's board of directors decides it's time to share some cash with the shareholders, they make an official announcement on what's called the declaration date. This announcement includes the amount of money each common share will receive.

After this announcement, they set a record date. This is the day when the company identifies the shareholders on record who are eligible to get that cash payout.

The amount is credited to the registered bank account (linked to the Demat account) on the payout date.

How To Calculate Cash Dividend?

Calculating cash dividends involves determining the total amount of cash that a company will distribute to its shareholders. 

Total Cash Dividend = Dividend Per Share × Number of Shares

Let's say you own 150 shares of XYZ Gadgets, and the company announces a cash dividend of ₹1.20 per share. This means that for every share you hold, you'll be receiving ₹1.20 as a dividend.

Here's how you calculate your cash dividend:

Cash Dividend per Share × Number of Shares = ₹1.20 × 150 = ₹180

You would receive ₹180 as your cash dividend. The company will then either mail you a check or deposit the money directly into your account, acknowledging your ownership in XYZ Gadgets with a financial perk.

Significance of Cash Dividends:

Who doesn’t like earning a little extra cash? Cash dividends provide instant gratification to investors, and the companies are also happy that their investors are happy. It is a way for companies to thank their shareholders, making them feel recognised and loyal.  

In fact, the issue of dividends has even given rise to a stock investment strategy! The ‘dividend strategy’ is one where investors identify companies issuing dividends regularly and create a portfolio with them.  This enables them to earn additional money regularly as passive income. 

On top of that, cash dividends can attract new investors. By sharing profits, companies build a strong bond with shareholders, making them feel confident in their investment choices and encouraging a long-term partnership. So, in simple terms, cash dividends are an important way to reward shareholders and bring in new ones.

Limitations of Cash Dividends:

• Reduced Reinvestment Opportunities:

When shareholders receive cash dividends, the companies have less money to reinvest for business growth. From an investor perspective, while extra cash is great, it may present itself as a missed opportunity to reinvest and benefit from the compounding power of money (Unsure what we are talking about? Here’s the link to our very first module - The Power of Compounding - for a quick refresher!).

• Market Perceptions:

Expectations of cash dividends impact market sentiment. The announcement of a payout or otherwise creates volatility in the market. 

• Pressure on Company Finances:

Paying out cash dividends requires companies to allocate part of profits to shareholders. When a company faces financial challenges or needs reinvestment, paying dividends might not be practical.

• Limited Growth Potential:

While cash dividends provide an alternate income stream, it also opens up discussion around missed opportunity cost - the money could’ve yielded better returns had it been reinvested..

• Tax Implications:

Cash dividends are typically taxable as income for shareholders. This taxation can affect your after-tax returns, potentially diminishing the appeal of cash dividends, especially for those in higher tax brackets.

• Market Expectations:

Once a company starts paying regular cash dividends, it's natural for one to expect this trend to continue. People tend to forget that dividends are not obligatory. A suspension could lead to disappointment and negative reactions from investors.

• Opportunity Cost:

The cash used for dividends could have been used for other purposes, such as debt reduction, acquisitions, or research and development. This opportunity cost might impact the company's long-term competitiveness and growth potential.

While cash dividends serve as a valuable means for companies to express gratitude to shareholders and provide an additional income stream, they come with trade-offs. We should be mindful of potential limitations. Balancing the benefits and drawbacks of cash dividends is crucial for companies and shareholders alike in making informed financial decisions.

2. Stock Dividends

A stock dividend involves providing shareholders with additional shares rather than cash. These distributions may be made even in fractions per existing share. 

For instance, if a company declares a stock dividend of 8%, it signifies that you will receive 0.08 shares for every share of the company you currently own. 

Let’s suppose you hold 150 shares of the company. In that case, you would be entitled to an extra 12 shares for free through this stock dividend! 

Now, here's the twist – while you get more shares, the overall value of each share might change a bit. This is because the total number of outstanding shares of the company is changing but the total market value is not. Look at it this way - one pizza was earlier cut into 4 slices, but now, the same pizza is cut into multiple pieces.   

Companies do this to show they're doing well and expect to keep doing well. For investors, the shares are a free addition to the portfolio that continues to compound until you decide to sell. 

Calculating Stock Dividend

Let's say you own 150 shares of XYZ Company, and the company announces a stock dividend of 10%. This means you will receive an additional 10% in new shares for each share you currently own.

Here's how you calculate the stock dividend:

Calculate the Number of New Shares:

Number of new shares = (Stock Dividend Percentage×Number of Existing Shares)

Number of new shares = (0.10×150) = 15

So, you would receive 15 new shares as part of the stock dividend.

Calculate the Total Number of Shares After Dividend:

Total number of shares after dividend=Number of Existing Shares+Number of New Shares

Total number of shares after dividend=150+15=165

After the stock dividend, you would have a total of 165 shares.

In this case, you would receive 15 new shares as a result of the 10% stock dividend, and your total ownership in XYZ Company would increase to 165 shares.

Advantages of Stock Dividends:

• Deferred Taxation:

Investors don't pay taxes on stock dividends until they decide to sell the shares.

• Potential Long-Term Gain:

Issuing stock dividends may temporarily lower the stock price, attracting more buyers and potentially benefiting current shareholders in the long run.

• Flexibility for Investors:

Shareholders can either sell the extra shares immediately in the stock market or hold onto them for the longer-term benefits of stock investing.

Limitations of Stock Dividends:

• Limited Immediate Reward:

Investors may not see immediate financial gain from receiving stock dividends.

• Possible Stock Price Decrease:

Issuing stock dividends may lead to a temporary decrease in the stock price.

3. Property Dividends

You read that right! But let’s put it upfront that this is the rarest of the rare kind of dividend a company may issue. A property dividend is a type of dividend payment in which a company distributes tangible assets or property to its shareholders instead of traditional cash or additional shares. This distribution may include physical assets such as real estate, equipment, or other valuable holdings owned by the company.

• Valuation: The value of the property distributed is usually determined based on appraisals or fair market values. Shareholders receive a portion of the company's assets equivalent to the declared dividend.
• Asset Types: Property dividends can encompass a wide range of assets, from real estate properties to machinery or any valuable holdings owned by the company. It could even be company products that it sends to its shareholders!
• Financial Strategy: Companies may opt for property dividends as part of their financial strategy, especially when the fair market value of the asset (current value) is different from its book value (the price at which the company may have acquired the asset).

4. Scrip Dividends

When companies issue scrip dividends, shareholders receive a certificate promising them a dividend issue at a later date. You reserve the right to choose whether you want the dividend in the form of cash or stock. 

From the company's standpoint, issuing scrip dividends can be a strategic move to conserve current cash. Remember the cost of opportunity we covered ahead? Read about it here.

By providing the option for shareholders to receive shares instead of cash, the company retains more liquidity for other financial needs.

• Impact on Share Capital: When shareholders opt for scrip dividends, it has an impact on the company's share capital. The issuance of additional shares increases the total number of shares outstanding.
• Tax Implications: Shareholders receiving scrip dividends should be aware of potential tax implications.

In essence, scrip dividends offer a flexible dividend distribution model that allows both companies and shareholders to navigate between cash and equity, catering to diverse financial preferences.

Calculating Scrip Dividend:

The formula for calculating the number of additional shares a shareholder receives in a Scrip Dividend is given by:

Number of Additional Shares=(Dividend Amount/Market Price per Share)× (1−Discount Rate)

• Dividend Amount: The total amount of the dividend declared by the company.
• Market Price per Share: The average market price per share, usually calculated over a specified period.
• Discount Rate: The reduction in the market price per share at which the Scrip Dividend shares are offered. It represents the discount provided to shareholders opting for additional shares.

Let’s take an example:

XYZ Corporation Scrip Dividend

• Dividend Amount: ₹1,00,000
• Market Price per Share: ₹50
• Discount Rate: 5%

Number of Additional Shares = (1,00,000/50)×(1−0.05)

Number of Additional Shares = 1,900

A shareholder choosing the Scrip Dividend option would receive approximately 1,900 additional shares in XYZ Corporation. The discount rate of 5% has been applied to adjust the market price per share for the Scrip Dividend offer.

Advantages of Opting for Scrip Dividends:

• Scrip Dividends offer shareholders flexibility, enabling them to customise their dividend receipt based on their unique financial situation and goals. Whether seeking immediate cash or aiming for long-term growth, you can choose an option that aligns with your specific requirements.
• Scrip Dividends often lead to cost savings for shareholders. In contrast to buying shares on the open market, where transaction costs like brokerage fees may apply, companies typically cover these costs in Scrip Dividend programs. This ensures that shareholders receive more shares without incurring additional fees, enhancing the overall value of their investment.

Drawbacks of Scrip Dividends:

• Scrip Dividends may trigger tax obligations despite not providing immediate cash.
• Opting for Scrip Dividends can tie up funds, limiting financial flexibility.
• Managing additional shares in Scrip Dividends can introduce administrative complexities for the issuing company.

5. Scrip Dividends Liquidating Dividend

A liquidating dividend is a type of distribution that occurs when a company decides to wind down its operations or sell off significant assets. Unlike regular dividends, which are paid out of the company's earnings, liquidating dividends are paid from the company's capital or the proceeds of asset sales. The purpose of a liquidating dividend is to return the remaining value of the company's assets to shareholders after all debts and other obligations have been settled.

Calculating Liquidating Dividend

Liquidating Dividend = Total Assets Sold - Total Liabilities - Costs of Liquidation.

The resulting value is the amount available for distribution to shareholders.

• Liquidating Dividend: The amount available for distribution to shareholders after the liquidation process.
• Total Assets Sold: The total value generated from selling off the company's assets.
• Total Liabilities: The sum of all outstanding debts and obligations that need to be settled during the liquidation process.
• Costs of Liquidation: Any expenses incurred during the liquidation process, such as legal fees or administrative costs. The company may sell off significant assets, such as real estate, equipment, or subsidiaries, to generate the necessary funds for the liquidating dividend. The proceeds from these asset sales are then distributed to shareholders.
• Tax Implications: Liquidating dividends can have tax implications for both the company and shareholders. Shareholders may be subject to capital gains taxes on the distribution of assets, depending on the difference between the liquidating dividend and their initial investment.
• Shareholder Approval: The decision to issue a liquidating dividend often requires approval from the company's board of directors and, in some cases, shareholders. Shareholders may need to vote on the liquidation plan.

6. Special Dividends:

A special dividend, also referred to as an extra dividend, is a non-recurring, “one-time” dividend distributed by a company to its shareholders. It is separate from the regular cycle of dividends.

These dividends are typically initiated by extraordinary events that result in a substantial influx of cash, such as:

• Windfalls: Companies may issue special dividends when they experience unexpected windfalls, like a significant sale of assets, favourable legal settlements, or unexpected gains.
• Excess Cash Reserves: Accumulated excess cash reserves, often beyond what the company needs for its regular operations or expansion can allow companies to give out dividends.
• Profitable Events: Extraordinary profits, such as a sudden surge in earnings or a successful business deal.
• Tax Efficiency: In some cases, companies may opt for special dividends as a tax-efficient way to distribute profits to shareholders.

An example of a special dividend in history is Microsoft Corporation's announcement of a significant one-time payout to shareholders in 2004. Microsoft declared a special dividend of $3 per share, totalling approximately $32 billion, in addition to its regular dividend.

The announcement had a notable impact on the stock market, and Microsoft's share price experienced a temporary surge following the news. Special dividends like this one are often seen as a way for companies to reward shareholders during periods of financial strength or when they have excess cash that may not be immediately needed for business operations or strategic investments.

Impact of Dividends on Stock Prices

By now, you’ve probably already figured out how important dividends are and how investors value them. Stock market investors often scrutinise dividend payments, recognising them not only as a source of income but also as a significant factor influencing the attractiveness of the stock itself. 

• Positive Market Sentiment:

When a company declares and consistently pays dividends, it signals financial health and stability. Such positive signals can elevate market sentiment and attract investors seeking reliable returns. As a result, stocks of dividend-paying companies often enjoy increased demand, contributing to upward pressure on stock prices.

• Income Stream and Yield Considerations:

Investors often assess a stock's dividend yield, calculated by dividing the annual dividend per share by the current stock price. A higher dividend yield can make a stock more appealing to income-focused investors, potentially driving demand and influencing stock prices positively.

• Market Expectations and Dividend Policies:

Some investors may form expectations based on a company's dividend policies. A consistent history of dividend payments may create an expectation of future payouts. We often forget it is not obligatory but rather only a reward. Nonetheless, any deviation from these expectations, such as a dividend cut or increase, can impact stock prices as investors recalibrate their outlook on the company.

• Market Perception During Economic Trends:

During economic downturns, dividend-paying stocks may exhibit resilience. Investors often seek stability and income during challenging times, making dividend-paying stocks an attractive option. This demand can influence stock prices, mitigating the impact of broader market declines.

You can see that the impact of dividends on stock prices is multifaceted, reflecting not only the financial performance of a company but also market sentiment, investor expectations, and broader economic trends. 

Before we wrap up this dividend party, here’s a quick bite of information listing the pros and cons of dividends!

Pros of Dividends

• Steady Income Source: Dividends offer a reliable income stream, particularly appealing to investors seeking consistent cash flow.
• Attraction for Investors: Dividend-paying stocks can draw in income-focused investors, broadening the investor base and potentially boosting demand.
• Fosters Investor Loyalty: Regular dividends enhance shareholder loyalty, creating a positive perception of dependable returns.
• Indication of Financial Well-being: Companies issuing dividends signal financial stability and confidence in profit generation, positively impacting investor trust.
• Facilitates Dividend Reinvestment: Investors can opt to reinvest dividends, acquiring additional shares and capitalising on the compounding effect.
• Tax Efficiency: In certain jurisdictions, qualified dividends enjoy preferential tax treatment, providing tax advantages for investors.

Cons of Dividends

• Diminished Reinvestment Opportunities: Dividend payouts limit funds available for company reinvestment, potentially constraining growth prospects.
• Market Perception Risks: A dividend cut may be viewed as a sign of financial troubles, leading to a negative impact on stock prices.
• Opportunity Costs: The cash allocated to dividends could be used for other purposes, representing an opportunity cost for the company.
• Meeting Market Expectations: Investor expectations for continuous dividends may result in disappointment and negative market reactions if not met.
• Growth Constraints: Companies prioritising dividends may have different growth potential compared to those reinvesting profits for expansion.
• Tax Implications for Investors: Dividends are usually taxable as income, and the tax burden may impact after-tax returns, particularly for those in higher tax brackets.
• Market Volatility Impact: Dividend-paying stocks may exhibit less resilience during market downturns as income-seeking investors shift to more stable assets.

Conclusion

Dividends serve as a valuable avenue for passive income in an investor’s portfolio. It is crucial to understand the different types of dividends and their influence on financial statements, key payment dates and dividend yields for evaluating investment decisions. With this understanding, you can make well-informed choices in-stock selection and optimise your overall investment returns.