Dividends – Forms, Advantages and Disadvantages

Definition of Dividend

It is a distribution of part of the company’s earnings to its equity shareholders. The company’s board of directors decides the amount that the shareholders will receive. The company can also state it in the form of a percentage.

The dividend is one of the important ways in which the companies communicate their financial health and shareholders’ value to the general public. Through the distribution of their earnings, companies indicate a positive future and a strong performance. The ability and the willingness of a company to pay stable dividends constantly over a good period of time and even at an increasing pace gives a good picture of the company’s fundamentals.

Different Forms / Types of Dividends

There are various forms of dividends in which a company pays its shareholders:

Cash Dividend

It is the most common form. The shareholders receive cash for each share. The board of directors announces the dividend payment on the date of declaration. The company assigns the dividends to those shareholders who were holding the status of the shareholder of that company on the date of records. The record date and ex-dividend date are two very important concepts. The dividends are issued on the date of payment. But for distributing cash dividends, the company needs to have positive retained earnings and enough cash for such distributions.

Dividend - Forms, Advantages and DisadvantagesBonus Share

Bonus share is also called the stock dividend. A company may have low operating cash but still want to keep the investors happy, issues such dividends.

Under this, each equity shareholder receives a certain number of additional shares depending on the number of shares originally owned by the shareholder. For example, suppose a person possesses 10 shares of Company A, and the company declares a bonus share issue of 1 for every 2 shares. In that case, the person will get 5 additional shares in his account without any payment. From the company’s angle, the company’s number of shares and issued capital will increase by 50% (1/2 shares). The market price, EPS, DPS, etc., will be adjusted accordingly. In this case, the company shall retain earnings also at the same time; the shareholders get returns. An investor who desires a cash return can sell the investment in the secondary market. The term for referring to this is the ‘capitalization of earnings.’

Share Repurchase

Share repurchase occurs when a company buys back its own shares from the market and reduces the number of shares outstanding. This is considered an alternative to the dividend payment as cash is returned to the investors in another way.

Property Dividend

The company makes the payment in the form of assets under the property dividend. The asset could be any of this equipment, inventory, vehicle, or any other asset. The asset’s value has to be restated at the fair value while issuing this.

Scrip Dividend

It is a promissory note to pay the shareholders later. This type is used when the company does not have sufficient funds for such issuance.

Liquidating Dividend

When the company returns the original capital contributed by the equity shareholders as a dividend, it is termed a liquidating dividend. It is often seen as a sign of closing down the company.

Dividend-Decision

Advantages of Paying Dividends

Paying returns to investors has several advantages, both for the investors and the company:

Investor Preference

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.

Bird-in-Hand Fallacy

Bird in hand theory states that the shareholders prefer the certainty of dividends in comparison to the possibility of higher capital gains in the future.

Stability

Investors prefer companies with a track record of paying dividends as it positively reflects their 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 stock’s growth. 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.

Information Signalling

When a company announces such returns, 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 returns also has several disadvantages:

Clientele Effect

Suppose a dividend-paying company is unable to pay returns to shareholders for a certain period of time. In that case, it may result in the loss of old clientele who preferred regular payments. These investors may sell off the stock in the short term.

Decreased Retained Earnings

When a company makes such payments, it decreases its retained earnings. Debt obligations and unexpected expenses can arise if the company does not have enough cash.

Limits Company’s Growth

Paying dividends results in the reduction of usable cash, limiting the company’s growth. The company will have less money to invest in business growth.

Logistics

The payment to shareholders requires a lot of record-keeping at the company’s end. The company has to ensure that the right owner of the share receives its payment.

Conclusion

Since dividends are important for keeping the investors happy, a company should diligently decide upon the time and form also how it calculates dividends. It should also keep its advantages and disadvantages in the mind before framing a dividend policy. A stock dividend calendar will be handy for investors and traders as it provides an overview regarding payment date, payout, type, etc.



Sanjay Borad

Sanjay Bulaki Borad

Sanjay Borad is the founder & CEO of eFinanceManagement. He is passionate about keeping and making things simple and easy. Running this blog since 2009 and trying to explain "Financial Management Concepts in Layman's Terms".

6 thoughts on “Dividends – Forms, Advantages and Disadvantages”

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  2. GOOD INFORMATION ON TYPES OF RETURN ON EQUITY IN A VERY SIMPLE LANGUAGE. THANKS FOR SERVICE RENDERED TO PEOPLE WHO ARE ON THE LOOK OUT FOR OBTAINING CLARITY IN SIMPLE LANGUAGE AND ALSO THOSE WHO WANT TO RECAPITULATE THEIR LEARNINGS TIME TO TIME.

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