Table of Contents
- 1 SPECIAL DIVIDEND DEFINITION
- 2 WHY DO COMPANIES PAY SPECIAL DIVIDEND
- 3 SPECIAL DIVIDEND’S EFFECT ON STOCK PRICE
- 4 DISADVANTAGES OF SPECIAL DIVIDEND
SPECIAL DIVIDEND DEFINITION
Special dividend is the non-recurring dividend distributed by the company to its shareholders. It is separate from the normal recurring cycle of dividends. It is also known as the extra dividend or irregular dividend. The amount distributed through special dividend is larger compared to the normal dividend.
Special dividend is generally distributed when the company has accumulated a large amount of cash with them. This pile-up of cash is the result of an occasional event. Such special circumstances could be:
- Series of exceptional earning for few years.
- The company has sold a subsidiary or a department or some assets
- Achieved a milestone. i.e. 50th anniversary of the company
- A major lawsuit win
WHY DO COMPANIES PAY SPECIAL DIVIDEND
Distribute the Extra Cash Available
When the company has a large amount of cash lying on their balance sheet, they choose to distribute it to shareholders through the special dividend. It makes more sense to distribute the cash to shareholders when a company does not have attractive reinvestment opportunities in near future. The shareholders will be able to invest that money somewhere better than the unappealing project.
Change the financial structure
Sometimes company distributes the special dividend to change the capital structure. It will reduce the equity and total assets. So it will increase the proportion debt in the capital structure and reduce the cost of capital.
Special dividends are a great way to reward shareholders. When shareholders receive some extra and unexpected cash, they are delighted. They are used by the company to show confidence in its long-term position and to increase shareholders’ faith in the company.
A Useful Tool for Cyclical Industries
Cyclical industries are affected significantly by the changes in economic outlook. Their earnings are unpredictable as they might make a profit in some periods and loss in some. Hence, cyclical industries use the special dividend to create a hybrid payout policy. They follow the normal dividend cycle and whenever earning are good in a particular period, they distribute it through the special dividend.
SPECIAL DIVIDEND’S EFFECT ON STOCK PRICE
Special dividend will have the same effect as a normal dividend on the price. On the ex-dividend date, the stock price will reduce by the amount of special dividend declared. For example, if the closing price of a stock one day before the ex-dividend date is $30. The company has announced a special dividend of $5/ Share. Theoretically, the price on the ex-dividend date should be $25 ($30 -$5). However, the market will reflect all the sentiments related to stock in the price. So, the price might be more or less than 25 depending on how investors interpret the result.
DISADVANTAGES OF SPECIAL DIVIDEND
Error in Judgment
Companies might announce special dividend thinking that they will have enough cash to fund its future projects even after declaring the special dividend. There are chances that company’s judgment could be wrong. In future, if some attractive opportunity comes up then the company might not be able to take advantage of it because it has disbursed the cash.
Lack of Investment Opportunities
Market might interpret that company is announcing special dividend because it does not have any project to invest in. Investors looking for growth would not want to be associated with the company which does not have reinvestment opportunities. This might drag the market price down. Many technology stocks are at their growth peak. They are facing the same issues.
The nature of special dividend is very unpredictable. The temporary growth in the cash is not an organic growth, it happens because of some special occurrence. So for a long-term investor, special dividend is not of that much importance. It has no effect or a small effect on valuation. Also, it is not considered in the calculation of the dividend yield.
A special dividend is an occasional event, so investors should not interpret it as a signal for higher future dividend income. Investing just for the special dividend is never a good strategy. Also, Companies should be cautious while taking the decision of special dividend as it can backfire. It has happened with some companies in past.
CFA Level 1 Curriculum, 2016March 28th, 2018