Educational

Dividends: Types of Dividend and the Pros and Cons

What is dividend?

Dividends 101 words on a blackboard in chalk.

Dividends are the distribution of reward from a share of company’s income, and is paid to a class of its shareholders.

A company’s dividend is decide by its board of directors and it needs the shareholders’ approval. However, it is not required for a company to pay dividend. Dividend is usually a part of the earnings that the company shares with its shareholders. The annual dividend per share divided by the share price is the dividend yield.

When a company pays dividends, its board of directors chooses what percentage of its profits to distribute to shareholders. Though dividends are generally paid monthly, a company that pays dividends is not obligatory to do so every quarter.

A dividend is allocate as a fixed amount per share with shareholders receiving a dividend in proportion to their shareholding. For the joint-stock company paying dividends is not an expense; somewhat, it is the division of after-tax earnings among shareholders.

Retained earnings (profits that have not been distributed as dividends) are shown in the shareholders’ equity section on the company’s balance sheet – the same as its issued share capital.

Public companies usually pay dividends on a fixed schedule, but may proclaim a dividend at any time. Sometimes it’s called a special dividend to differentiate it from the fixed schedule dividends. Cooperatives, on the other hand, allocate dividends according to members’ activity, so their dividends are often considered to be a pre-tax expense.

See also: The Best Dividend Stocks to Invest In

How a dividend works

Dividend on letter cube with stock graph and dollar background.

A dividend’s value is determined on a per share basis and is to be paid equally to all shareholders of the same class, for example, common, preferred, etc. The payment of a dividend must be accepted by the committee.

When dividend is declared, it will then be paid on a certain date, known as the payable date.

Steps of how it works:

1. The company generates income and retained earnings.

2. The board team decided some excess income should be paid out to shareholders (instead of being invested).

3. The board approves the planned dividend.

4. The company declares the dividend (the value per share, the date it will be paid, the record data etc.)

5. The dividend is paid to shareholders.

Important Dates Linked with Dividend

Dividend payout announcement.Concept of return on investment.

Announcement Date

Dividends are announced by the company board on the announcement date, and must be accepted by the stockholders before they can be paid.

Ex-Dividend Date

The ex-date, or ex-dividend date, is the date on or after which a security is traded without a previously announced dividend or distribution. After the ex-date, a stock is said to trade ex-dividend. The ex-date is the date on which the seller, and not the purchaser, of a stock will be entitle to a lately announced dividend.

Record Date

The record date is the cut-off date, established by a company, in order to define which shareholders are qualified to receive a dividend or distribution.

Payment Date

The company issues the payment of the dividend on the payment date, which is when the money gets accredited to investor’s account.

Types of Dividends

Hand putting coin in jar word dividend with money stack.

There are different types of dividends a company can pay to its shareholders.  Below you will find a list and a brief description of the most common types shareholders receive.

Cash Dividend

The cash dividend is definitely the most common of the dividend types used. On the date of announcement, the committee solves to pay a certain dividend amount in cash to those investors holding the company’s stock on a particular date. The date of record is the date on which dividends are allocated to the holders of the company’s stock. On the date of payment, the company issues dividend payments.

When a company chooses to distribute cash dividends, those who hold its stock receive payments based on the number of shares they own.

The companies should have a sufficient retained income and enough cash balance to pay the shareholders in cash.

Stock Dividend

A stock dividend is the issuance by a company of its common stock to its common shareholders without any payment. If the company issues below 25 percent of the total number of previously remaining shares, then treat the transaction as a stock dividend.

If the transaction is for a better proportion of the previously remaining shares, then treat the transaction as a stock split.  To record a stock dividend, move from retained earnings to capital stock and other paid-in capital accounts an amount equivalent to the fair value of the additional shares issued. The fair value of the extra shares issued is based on their fair market value when the dividend is announced.

Property Dividend

Several types of dividend distributions are nonmonetary dividends. For example, you may accept a property or product dividend. Property includes products that the company brands (or even product samples), services that the company offers or stock from a subsidiary it owns.

 Product samples dividends are not usually given, but this is a permissible dividend distribution. Typically, a company does not have to allow prior notice to its shareholders when it issues property dividends, and the dividends are taxed based on their value.

 A company may choose to pay its shareholders in property dividends if they’re facing financial trouble and its cash flow is compromise.

Scrip Dividend

Scrip dividend means payment of dividend in scrip or promissory notes. Sometimes companies need cash generated by business income to meet business needs or withhold the payment of cash dividend due to temporary lack of cash.

In such cases the company may issue scrip or notes promising to pay dividend at a future date. The scrip commonly bears a certain date of maturity. Sometimes maturity date is not specified and its payment is left to the discretion of Board of Directors. Scrip may be interest bearing or non-interest bearing. Such dividends are relatively uncommon.

Liquidating Dividend

When the board of the company thinks of giving back the original capital invested by the shareholders then it is known as the liquidating dividend. This may occur because of the fact the company plans to wrap up the business.

These are commonly paid at the time of end of the operations of the company or at the time of final closure. Therefore, it is found out that usually the dividends are paid in cash, but however in certain situations, there could be the other forms of dividend as explained above.

Conceptual business illustration with the words dividend tax.

As one can see from the above that dividends payment has advantages as well as disadvantages and whether dividends should be paid or not is purely dependent on the financial condition of the firm and also on the management future outlook border the company.

Advantages of Dividends

1. The most important advantage of dividend is that investors who have invested in the company become more happy and self-assured about the company because everyone likes to have additional when it comes to earning money and in case of stocks, dividend is the only source of profits for shareholders separately from capital appreciation of stocks.

2. One more advantage of dividends is that in many countries dividend revenue is tax free because tax is taken at source that is on distribution of income by company and therefore when investor gets dividend he or she will not have to pay taxes on dividend income.

3. Another advantage of dividend is that people who are old like to have continuous source of income and if they invest in stock market they will more likely to invest in those companies which pay regular dividend instead of those company which pay irregular or no dividend and hence dividend attracts this class of investors to invest in the company.

4. In stock markets a concept known as informational signaling is very significant. According to this concept if company has strong balance sheet than investors would get to know about it only when firm signals it by paying dividend or issuing bonus share as every investor does not have sufficient financial knowledge about the various financial statements and common investor will be happy only when he or she receive some subsidy in the form of dividend or bonus issue.

Disadvantages of Dividends

1. The main disadvantage of dividends is that by paying dividend company runs out of cash which could be used for investing into the business which in turn would have resulted in more development for the company. In a way dividend results in sacrificing long term growth for short term profit.

2. Another disadvantage of paying dividend is that company has to pay tax on distribution of income which would not have the circumstance if the company had invested the amount into the business and hence in way it dividend results in extra tax burden for the company.

3. If company pays dividend in 1 year and fails to pay in other years then investor concern about the future of the company and begins selling stock which results in downward pressure on the stock price and unwanted negativity about the company. Hence it is better for a company to pay stable dividends instead of erratic dividends because stock market is full of speculation and even if the financial position of company is strong and still company choose not to pay dividend then it may lead to speculation that company is in financial stress.

Conclusion

A lot of investors seek dividend-paying stocks as a means of growing wealth and generating income, especially in the retirement years. As with any investment, it’s significant to do your own homework and find investments that are appropriate to your investing style, time horizon, risk tolerance and financial objectives. A variety of resources and tools are accessible in print and online to help you make up-to-date investment choices.

When in hesitation – or even if you’d just like verification – it’s recommended that you consult with a experienced financial planner and tax expert to define the best course of action for your general investment strategy.

See also: Dividend Reinvestment Plan: Important Things Every Investor Should Know

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