The dividend is one of the important ways in which the companies communicate the financial health and the shareholder value. Through a distribution from their earnings, companies indicate a positive future and a strong performance. The ability and the willingness of a company to pay stable dividends over a good period of time and even increase them steadily gives a good picture about the fundamentals of the company.
Table of Contents
- 1 Definition of Dividend
- 2 Different Forms / Types of Dividends
- 3 Advantages of Paying Dividends
- 4 Disadvantages of Paying Dividends
Definition of Dividend
A dividend is a distribution of part of the earnings of the company to its equity shareholders. The board of directors of the company decides the dividend amount to be paid out to the shareholders. Mostly, a dividend is stated as an amount each equity share gets. It can also be stated as a percentage.
Different Forms / Types of Dividends
There are various forms of dividends that are paid out to the shareholders:
A Cash dividend is the most common form of the dividend. The shareholders are paid in cash per share. The board of directors announces the dividend payment on the date of declaration. The dividends are assigned to the shareholders on the date of record. The dividends are issued on the date of payment. But for distributing cash dividend, the company needs to have positive retained earnings and enough cash for the payment of dividends.
Bonus share is also called as the stock dividend. Bonus shares are issued by the company when they have low operating cash, but still want to keep the investors happy. Each equity shareholder receives a certain number of additional shares depending on the number of shares originally owned by the shareholder. For example, if a person possesses 10 shares of Company A, and the company declares bonus share issue of 1 for every 2 shares, the person will get 5 additional shares in his account. From company’s angle, the number of shares and issued capital in the company will increase by 50% (1/2 shares). The market price, EPS, DPS etc will be adjusted accordingly. In this case company shall retain earning also at the same time share holder gets dividend. An investor who desires cash return, can sell investment in secondary market. It is also called capitalization of earning.
Share repurchase occurs when a company buys back its own shares from the market and reduces the number of shares outstanding. This is considered as an alternative to the dividend payment as cash is returned to the investors through another way.
The company makes the payment in the form of assets in the property dividend. The asset could be any of this equipment, inventory, vehicle or any other asset. The value of the asset has to be restated at the fair value while issuing a property dividend.
Scrip dividend is a promissory note to pay the shareholders later. This type of dividend is used when the company does not have sufficient funds for the issuance of dividends.
When the company returns the original capital contributed by the equity shareholders as a dividend, it is termed as liquidating dividend. It is often seen as a sign of closing down the company.
Advantages of Paying Dividends
Paying dividends to investors has several advantages, both for the investors and the company:
Investor Preference for Dividends
The investors are more interested in a company that pays stable dividends. This assures them of a reliable source of earnings, even if the market price of the share dips.
This theory states that the shareholders prefer the certainty of dividends in comparison to the possibility of higher capital gains in future.
Investors prefer companies that have a track record of paying dividends as it reflects positively on its stability. This indicates predictable earnings to investors and thus, makes the company a good investment.
Benefits without Selling
Investors invested in dividend-paying stocks do not have to sell their shares to participate in the growth of the stock. They reap the monetary benefits without selling the stock.
Temporary Excess Cash
A mature company may not have attractive avenues to reinvest the cash or may have fewer expenses related to R&D and expansion. In such a scenario, investors prefer that a company distributes the excess cash so that they can reinvest the money for higher returns somewhere else.
When a company announces the dividend payments, it gives a strong signal about the future prospects of the company. Companies can also take advantage of the additional publicity they get during this time.
Disadvantages of Paying Dividends
Paying dividends also has several disadvantages:
If a dividend-paying company is unable to pay dividends for a certain period of time, it may result in loss of old clientele who preferred regular dividends. These investors may sell-off the stock in short term.
Decreased Retained Earnings
When a company pays dividends, it decreases its retained earnings. Debt obligations and unexpected expenses can rise if the company does not have enough cash.
Limits Company’s Growth Paying dividends results in
Paying dividends result in the reduction of usable cash which may limit the company’s growth. The company will have less money to invest in the business growth.
The payment of dividends requires a lot of record-keeping at the company’s end. The company has to ensure that the right owner of the share receives the dividend.
Since dividends are important for keeping the investors happy, a company should decide upon the time and the form of dividends diligently. It should also keep in the mind the advantages and the disadvantages of the dividends before framing a dividend policy.1,2