Dividend Definitions – What is a Dividend?
By: Ned Piplovic,
Before embarking into the exciting realm of investing for dividend income, investors must learn and understand a few basic dividend definitions to maximize dividend income distributions and minimize risk of potential pitfalls that could lead to losses
“What is a dividend?” That is the first question that interested income investors should ask.
While successful dividend investing over the long term involves many aspects and considerations, as far as dividend definitions go, the payment of a dividend is quite simple. A dividend simply is a distribution of earnings or assets that equities make periodically to the equity’s stakeholders. From the investing perspective, dividends are distributions of a portion of a corporation’s earnings.
Dividend Definitions – What’s in a Name?
Depending on whether equities use earnings, assets, interest or other sources for payments to the stakeholders, a dividend might technically be a “distribution.” For simplicity and ease of understanding, many investors – especially novices and part-time investors – will use the word “dividend” as an all-encompassing term for all types of payments. Before moving to discuss other dividend definitions and concepts, I will outline briefly the technical differences between the two designations.
Officially, a dividend is a disbursement of a company’s earnings and generally applies to distributions from C-corporations, real estate investment trusts (REITs) or similar business entities. Conversely, S-Corporations, master limited partnerships (MLPs), limited liability companies (LLCs), trusts and estates technically pay “distributions”. Additionally, money market funds, certificates of deposit (CDs), bonds and exchange-traded debt securities pay interest.
Mutual funds can distribute both types of payments. Because mutual funds own shares of companies, the funds pass through any dividends paid by the underlying holdings as dividend payments to the fund’s equity holders. However, the mutual fund will channel through any proceeds from stock sales and capital gains as distributions. While mutual fund dividends usually follow the same tax rates schedule as ordinary income, mutual fund distributions are taxed at capital gains rates, which generally are lower than ordinary income rates.
For sake of simplicity and consistency, I will use the term “dividends” in the rest of this article to mean all distribution types – unless the distinction is a crucial component of any dividend definitions and concepts.
Dividend Definitions – Dividend Types
Distributions involve exclusively cash payments and most dividend payouts are made in cash, as well. However, occasionally equities will distribute in-kind dividends. For example, in-kind dividend types include stock dividends, property dividends, options to gain stock in another corporation, bonds of the company distributing dividends, bonds of a different corporation, government bonds, accounts receivables and promissory notes.
The only form of in-kind dividend still distributed with any significant frequency are stock dividends. For this type of dividend distribution, an equity will issue shares of the company’s stock equivalent to the cash value of the declared dividend distributions. Because the Internal Revenue Service (IRS) deems stock dividends as stock splits, dividend recipients carry no tax liability until the shares are sold, which could be many years later. The main benefit to the equity distributing the stock dividends is that this distribution has no impact on the equity’s cash flow.
Dividend Definitions – Distribution Frequency
Equities are free to choose any dividend distribution frequency. The most common distribution frequencies are quarterly and monthly. Additionally – because it aligns with the local requirement to report financial results twice per year – many companies based in Europe and Japan pay their dividends semiannually. Some equities, such as many mutual funds, distribute dividends once per year after their year-end financial reconciliation. The companies and equities use the monthly distribution frequency to attract investors who derive much of their income from investments and seek reliable monthly payments to cover their expenses. Such investors include retirees and other individuals on fixed income.
Dividend Definitions – Dividend Dates
The dividend distribution cycle has four important dates that can greatly affect income payments and total returns. While equities set some of these dates arbitrarily, others are set in specific relation to other dates.
Companies use the Declaration Date to announce to the public the information regarding upcoming dividend distribution details. Dividend declarations generally include the dividend amount for the upcoming period and the remaining three dividend dates.
Ex-Dividend Date determines which investors will receive the upcoming dividend payment. To receive the next round of dividend distributions, investors must own the shares of the equity at least one day before the ex-dividend date. The term “ex-dividend” means “without dividend” in Latin.
On the Record Date, equities compile the list of shareholders who are eligible to receive the next dividend distribution. The record dates used to be up to a month or more after the ex-dividend date when all records were kept manually a few centuries ago. However, with the automation of record keeping and communications improvements, the current requirement is that the ex-dividend date occurs two days before the record date.
Pay Date is the date when equities send out the actual dividend payments – generally in the form of electronic money transfers or physical checks.
Dividend Definitions – Dividend Metrics
Dividend yield is the simplest measure of dividend valuation. This measure expresses the ratio of the annual dividend distribution amount and the company’s current share price as a percentage. The dividend yield can be expressed as a trailing metric – using the actual total dividend distributions over the past year for the calculation – or as a forward measure, which uses the total annual dividend expected over the upcoming 12 months for the calculation.
One major downside is that the dividend yield can be misleading on its own as it is inversely related to the equity’s share price. Investors like to see a high dividend yield when supported by additional indicators. However, a sudden dividend yield increase is sometimes driven by a rapidly declining share price.
An additional dividend measure that investors should analyze is the Dividend Payout Ratio. This ratio shows what share of total earnings is paid out as dividends. Generally, investors look for a dividend payout ratio between 30% and 50%, which is low enough to support current income distributions, as well as future dividend hikes. Lower ratios indicate that the equity does not distribute enough of its earnings to the stakeholders. Alternatively, ratios higher than 50% – and especially above 100% – signal that the equity might not be able to sustain current levels of dividend payouts for much longer. It is important to note that these rules do not apply to all types of equities. Some equities must distribute a specific share of earnings to qualify for certain benefits. For instance, to qualify for lower taxation rates, REITs must distribute at least 90% of their earnings as dividends.
Dividend Definitions – Rising Dividends
Another significant consideration for picking the best dividend-paying equities is the history of dividend increases. Whether measured compared to the previous year, the last few quarters or decades, investors seek equities that show a steady streak of rising dividend payouts. A flat dividend payment losses value over time because of inflation and the dividend yield declines against a rising share price.
This article attempted to answer the “What is a dividend?” question in the most basic terms. While that is a good start, investors interested in dividend income should expand their understanding about the subject and a good next step would be the list of 20 important dividend definitions. However, despite many complex implications and nuances, disciplined investing in dividend-paying equities can reward investors with outsized total returns and financial security over extended time horizons.
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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.