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Step-by-Step Guide to Understanding Dividends in Corporate Finance

Last Updated August 10, 2023

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What is the Definition of a Dividend?

Companies often opt for dividend issuances when they have excess cash on hand with limited opportunities for reinvesting into operations.

Since the objective of all corporations is to maximize shareholder value, management can decide in such a case that returning funds directly to shareholders could be the best course of action.

For publicly-listed companies, dividends are frequently issued to shareholders at the end of each reporting period (i.e. quarterly).

The distribution of dividends can have two classifications:

  • Preferred Dividends
  • Common Dividends

Preferred dividends are paid out to holders of preferred shares, which take precedence over common shares – as implied by the name.

More specifically, common shareholders are contractually restricted from receiving dividend payments if preferred shareholders receive nothing.

Yet, the reverse is acceptable, in which preferred shareholders are issued dividends and common shareholders are issued none.

What are the Different Types of Dividends? (Cash vs. Stock)

The form of payment on the dividend issuance could be:

  • Cash Dividend: Cash Payments to Shareholders
  • Stock Dividend: Stock Issuances to Shareholders

Cash dividends are much more common.

For stock dividends, shares are given to shareholders instead, with the potential equity ownership dilution serving as the prime drawback.

Less common dividend types include the following:

  • Property Dividend: Distribution of Assets or Property to Shareholders in lieu of Cash/Stock
  • Liquidating Dividend: Return of Capital to Shareholders Anticipating Liquidation

Dividend Formula

There are three common metrics used to measure the payout of dividends:

  • Dividends Per Share (DPS): The dollar amount of dividends issued per share outstanding.
  • Dividend Yield: The ratio between DPS and the latest closing share price of the issuer, expressed as a percentage.
  • Dividend Payout Ratio: The proportion of a company’s net earnings paid out as dividends to compensate common and preferred shareholders.

The formulas for the dividend per share (DPS), dividend yield, and dividend payout ratio are shown below.

Dividend Per Share (DPS) = Dividends Paid / Number of Shares Outstanding
Dividend Yield (%) = Annual Dividend Per Share (DPS) / Current Share Price
Dividend Payout Ratio = Annual DPS / Earning Per Share (EPS)

Dividend Calculation Example

For example, let’s say that a company issues a dividend of $100 million with 200 million shares outstanding on an annualized basis.

  • Dividend Per Share (DPS) = $100 million ÷ 200 million = $0.50

If we assume the company’s shares currently trade at $100 each, the annual dividend yield comes out to 2%.

  • Dividend Yield = $0.50 ÷ $100 = 0.50%

To calculate the dividend payout ratio, we can divide the annual $0.50 DPS by the EPS of the company, which we’ll assume is $2.00.

  • Dividend Payout Ratio = $0.50 ÷ $2.00 = 25%

Dividend Stocks: What Types of Companies Issue Dividends?

Low-growth companies with established market positions and sustainable “moats” tend to be the type of companies to issue higher dividends (i.e. “cash cows”).

Market leaders exhibiting low growth are more likely to distribute more dividends, especially if disruption risk is low.

On average, the typical dividend yield tends to range between 2% and 5% for most companies.

But certain companies have dividend yields that are much higher – and are often referred to as “dividend stocks”.

Examples of Dividend Stocks

Some notable companies that have historically issued high dividends are the following:

  • Johnson & Johnson (NYSE: JNJ)
  • The Coca-Cola Company (NYSE: KO)
  • 3M Company (NYSE: MMM)
  • Philip Morris International (NYSE: PM)
  • Phillips 66 (NYSE: PSX)

What are Examples of Sectors with High vs. Low Dividends?

The sector in which the company operates is another determinant of the dividend yield.

Examples of sectors with the highest dividend yields include the following:

  • Basic Materials
  • Chemicals
  • Oil & Gas
  • Financials
  • Utilities
  • Telecom

Conversely, sectors with higher growth and more vulnerability to disruption are less likely to issue high dividends (e.g. software).

High-growth companies frequently opt to re-invest after-tax profits to reinvest into operations for purposes of achieving greater scale and growth.

What are the Key Dates of Dividend Issuances?

Declaration, Ex-Dividend, Holder-of-Record, and Payment Date

The most important dates to be aware of for tracking dividends are the following:

  • Declaration Date: Issuing company releases a statement declaring the intent to pay a dividend, as well as the date on which the dividend will be paid.
  • Ex-Dividend Date: The cut-off date for determining which shareholders receiving a dividend – i.e. any shares purchased after this date will not be entitled to receive a dividend.
  • Holder-of-Record Date: Typically one day after the ex-dividend date, the shareholder must have purchased shares at least two days prior to this date to receive a dividend.
  • Payment Date: The date when the issuing company actually distributes the dividend to shareholders.

How Do Dividend Issuances Impact the 3-Statements

  • Income Statement: Dividend issuances do not appear directly on the income statement and have no impact on net income – but rather, there is a section below net income that states the dividend per share (DPS) for both common and preferred shareholders.
  • Cash Flow Statement: The cash outflow of the dividend appears in the cash from financing activities section, which reduces the ending cash balance for the given period.
  • Balance Sheet: On the assets side, cash will decline by the dividend amount, whereas on the liabilities and equity side, the retained earnings will decline by the same amount (i.e. retained earnings = prior retained earnings + net income – dividends).

Are Dividends an Expense?

In short, dividends are not recognized as an expense. Instead, the issuance of dividends is a distribution of profits to shareholders.

The decision to distribute dividends reflects the company’s priority to return a portion of its earnings to its shareholders, rather than reinvesting that capital back into the business.

While not a set rule, most companies that proceed with returning capital to shareholders via dividends have limited opportunities to reinvest their earnings, which often coincides with a stagnant business in terms of the growth trajectory.

Management likely made the decision that it would be in the best interests of the shareholders to issue dividends than to pursue unappealing projects that could destroy shareholder value, as opposed to creating it.

But of course, there are exceptions to the rule. For example, a company could issue a one-time dividend to shareholders while exhibiting high growth, merely because of the amount of cash accumulating on its balance sheet.

Expenses are recognized on the income statement and reduce a company’s revenue, yet dividends never appear above net income (the “bottom line”).

But rather, dividends come out of the retained earnings line item on the balance sheet, which is a part of the shareholders’ equity section.

Therefore, dividends are paid out of the accumulated accounting profits once all expenses – both operating and non-operating items – have been accounted for.

How Do Dividends Impact Stock Prices?

Dividends can impact the valuation of a company (and share price), but whether the impact is positive or negative depends on how the market perceives the move.

Since dividends are often issued by companies when the opportunities to re-invest into operations or spend cash (e.g. acquisitions) are limited, the market can interpret dividends as a sign that the company’s growth potential has stalled.

The impact on the share price should be relatively neutral theoretically, as the slowing growth and announcement were likely anticipated by investors (i.e. not a surprise).

The exception is if the company’s valuation was pricing in high future growth, which the market may correct (i.e. cause the share price to decline) if dividends are announced.

What are the Pros/Cons of Dividends vs. Stock Buybacks?

Shareholders can be compensated through two means:

  1. Dividends
  2. Share Repurchases (i.e. Price Appreciation)

In recent times, share buybacks have become the preferred option for many public companies.

The benefit of share buybacks is that it reduces ownership dilution, making each individual piece of the company (i.e. share) become more valuable.

From the “artificially” higher earnings per share (EPS), the share price of the company can also see a positive impact, especially if the company fundamentals point towards upside potential.

Another benefit that share repurchases have over dividends is the increased flexibility in being able to time the buyback as deemed necessary based on recent performance.

Unless clearly stated to be a special “one-time” issuance, dividend programs are rarely adjusted downward once announced.

If a long-term dividend is cut, the reduced dividend amount sends out a negative signal to the market that future profitability could decline.

The final downside to dividend issuances is that dividend payments are taxed twice (i.e. “double taxation”):

  1. Corporate Level
  2. Shareholder Level

Unlike interest expense, dividends are not tax-deductible and do not reduce the taxable income (i.e. pre-tax income) of the issuing company.

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