Cash Dividends – Defined and Explained
By: Ned Piplovic,
Cash dividends are the most common method used to distribute an equity’s earnings or assets to stakeholders in the form of cash equivalents — generally checks or direct money transfers.
Types of Dividend Distributions
Cash dividends are one of the two primary dividend distribution categories. In addition to cash dividends, equities occasionally distribute in-kind dividends. These in-kind distributions include stock dividends — the most common method of in-kind dividends — as well as property dividends, bonds of the company distributing dividends, bonds of a different corporation, government bonds, accounts receivables, promissory notes, etc.
In-kind dividends have certain advantages, especially on the equities cash flow and the investor’s tax liability. However, due to their simplicity of distribution, accounting and management, the most common type of dividend payouts are cash dividends.
Some equities make their decision regarding dividend payouts based on the financial results for every individual period. However, well-established companies with extensive historical records of dividend distributions will generally have a set dividend policy that will define the guidelines and targets for dividend distributions. Companies with defined dividend policies attract income-seeking investors more easily than equities with sporadic dividend payouts. Therefore, companies with dividend policies generally can reliably raise funding for current operations and capital expenditures, which are two important factors for long-term sustained profitability.
Advantages and Disadvantages of Cash Dividends
The main advantages of cash dividends are ease of distribution and ease of accounting for corporate and individual investor taxation purposes. Investors — especially those that rely on a steady inflow of dividend income to cover living expenses — enjoy the liquidity of cash dividends, which can easily be used for immediate spending, reinvesting or other purposes. Another advantage is that cash distributions do not dilute the current stock of shares, which makes the share price level relatively unaffected by the dividend payouts. The only impact is share price’s adjustment lower by the cash dividend per share amount on the ex-dividend date.
The downside of cash dividends for the distributing equity is that it affects the company’s cash position. Therefore, a company that has even a temporary cash flow problem might have to reach to other resources — such as a sale of assets or short-term borrowing — to cover the funds needed to fully cover the cash dividend distribution. Alternatively, the company might have to cut the amount of the cash dividend payout or outright cancel that period’s round of dividend distributions.
Furthermore, the drawback for investors is that cash dividend distributions are generally subject to taxation at ordinary income tax rates. These rates are usually higher than capital gains tax rates applicable to some in-kind dividends like stock dividends.
Most equities’ dividend distribution schedules follow their financial reporting calendar. This alignment allows for more streamlined and simplified accounting procedures. North American companies are currently subject to quarterly financial reporting and most dividend-paying companies distribute their dividends four times per year. However, many mutual funds, Master Limited Partnerships (MLPs), Exchange-Traded Funds (ETFs), Real Estate Investment Trusts (REITs) and similar investment vehicles, opt for monthly cash dividend payouts. Furthermore, because of the local requirement to report financial results only once every six months, many companies that are based in the European Union and Japan disseminate their cash dividend distributions only twice per year. Finally, some companies also distribute their cash dividend payouts only once per year — following their year-end financial results.
Measuring Cash Dividends
To determine the best source of cash dividend income for their portfolio strategy, investors must evaluate several dividend metrics before making their final selection. The dividend yield is generally the first dividend metric that investors consider. This measure is a simple ratio of the company’s total annual cash dividend payout amount and the company’s share price at the time. Expressed as percentage, the dividend yield shows the total dividend income that can be expected on an investment over a one year period.
The actual total dividend payout amount over the previous year and the current share price give a trailing dividend yield figure. Alternatively, using the current period’s dividend payout amount to estimate the total annualized dividend amount expected over the subsequent 12 months indicates a forward yield.
However, while simple to calculate from two easily-accessible pieces of information, the dividend yield can be misleading, especially when using dividend yield trends for equity selection. The dividend yield and the equity’s share price are inversely proportional. Therefore, a sudden drop or a steady share price decline will result in a dividend yield increase. A higher yield generated by falling share prices means higher income returns for new investors. However, existing investors that took a position in the company’s stock at higher prices will lose much more on the asset depreciation than the gains received from cash dividend income. Therefore, additional metrics must accompany the dividend yield for a more complete equity evaluation.
One of the additional metrics is the dividend payout ratio. This ratio represents the share of net earnings that a company distributed as dividend payouts. The payout ratio is also the ratio of the annual dividend per share and the earnings per share (EPS). Investors generally consider as sustainable, over the long-term, a payout ratio in the 30% to 50% range.
A dividend payout in that range indicates that a company distributed a portion of its earnings that is sufficient to provide investors with a robust dividend income. Additionally, the payout ratio below the upper limit of that range implies that the company distributes no more than half of its earnings as dividends, which leaves enough funds for supporting other business operations.
Another important point of concern for equity selection is dividend growth. Even dividend distributions that increase every year generally grow slower than the share price, which results in diminished income returns. Additionally, back-tested data suggests that equities with long records of rising dividends tend to offer higher total returns over extended time horizons than their non-dividend peers.
Also, while not a quantitative measure of cash dividend performance, investors should pay attention to the important dividend dates to maximize their cash dividend income distributions.
Taxation of Cash Dividends
Most cash dividend distributions are subject to ordinary income tax rates. However, the Internal Revenue Service (IRS) provides a specific set of requirements that an equity must meet to enjoy taxation at the lower capital gain rates. Generally, only a U.S. corporation or a qualified foreign corporation that is not of the type listed by the IRS as “Dividends that are not qualified dividends,” are eligible for capital gains rates. Additionally, to claim qualified status for dividend distributions investors must meet a specific stock holding period outlined by the IRS.
As defined in the Tax Cuts and Jobs Act (TCJA) passed by Congress on December 22, 2017, the following tax rates are currently in effect for all cash dividend earnings starting with the 2018 tax year.
Tax rates for ordinary cash dividends:
However, the cash dividend distributions that manage to attain the qualified dividend status enjoy lower rates and only three tax brackets.
Hopefully, this article provided a few of the basic cash dividend principles that even novice investors can use as a foundation to build their understanding of cash dividends. An extensive understanding of cash dividend nuances will allow knowledgeable investors to sidestep any potential hazards and build a robust income-generating portfolio.
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Ned Piplovic is the assistant editor of website content at Eagle Financial Publications. He graduated from Columbia University with a Bachelor’s degree in Economics and Philosophy. Prior to joining Eagle, Ned spent 15 years in corporate operations and financial management. Ned writes for www.DividendInvestor.com and www.StockInvestor.com.