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What are dividends?

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“What are dividends?” is a question that has a rewarding answer in the form of income or another asset that is paid to the shareholder of a stock.

Dividends basically are asset distributions of in a company to its stakeholders. From the investing perspective, dividends are distributions of a portion of a corporation’s earnings.

This elementary definition of dividends is enough to answer the basic question, “What are dividends?” However, we have different types of dividends that can consist of cash and non-cash assets.

Types of Dividend Distributions

Dividends generally are distributed to shareholders as periodic cash payments. However, companies occasionally will distribute a portion of their earnings as stock dividends – shares equivalent to the value of declared dividends distributed to the shareholders.

Stock dividends are just one of the non-cash types of dividends that fall into the in-kind dividend category. While much more infrequent than stock dividends, other forms of in-kind dividends include options to gain stock in another corporation, bonds of the company distributing dividends, bonds of a different corporation, government bonds, and accounts receivable and promissory notes. Because the Internal Revenue Service (IRS) deems stock dividends as stock splits, the IRS does not treat stock dividends as taxable distributions.

Additionally, another form of in-kind distributions consists of property dividends, in which a company distributes its products or services to the shareholders. While property dividends have some advantages – the company retains its cash and does not dilute its stock as is done with stock dividends – the disadvantages unusually greatly outnumber the advantages.

Disadvantages of property dividends versus cash or stock dividends are similar to the disadvantages of the barter-exchange system compared to a monetary-exchange system. A company generally uses the retail price to calculate the quantity of the product equivalent to the declared cash dividend. However, the investor would have to find a buyer willing to pay that price or would have to sell at a discount and lose a portion of its dividend distribution.

Additionally, many investors, if not most, view a public company as a pure investment opportunity without the desire to use its products or services. For instance, investors might desire to take advantage of Apple, Inc. (NASDAQ:AAPL) share-price growth, but prefer to use Android-based phones and tablets from Samsung. For the reasons mentioned above and other inefficiencies, property dividends are extremely rare today.

When Are Dividends Not Dividends

While there generally is no harm in identifying all earnings and asset distributions as “dividends,” some distributions are technically not dividends. Dividends are earnings distributions from C-corporation and limited liability companies (LLCs), as well as real estate investment trusts (REITs) or any type of mutual funds.

However, master limited partnerships (MLPs), for instance, technically pay “distributions.” Additionally, money market funds, certificates of deposit (CDs), bonds and exchange-traded debt pay “interest.”

In addition to different terminology, some types of organizations and entities can choose whether to distribute dividends at all, as well as choose the portion of their earnings distributed to their investors. C-corporations, LLCs and MLPs are examples of entities that have free reign over their dividend distribution. Conversely, entities such as REITs, business developments companies and mutual funds must follow specific legal and regulatory requirement regarding their distributions. For instance, to achieve and retain favorable tax status, a REIT “must distribute at least 90 percent of its taxable income to shareholders annually in the form of dividends.”

However, regardless of whether they technically are “dividends,” “distributions” or “interest,” I will use the term “dividends” in the rest of this article for the sake of simplicity and consistency.

Regardless of details and specific requirements, dividend distributions ensure a steady income flow to the shareholders, which can be distributed at various frequencies throughout the year.

Distribution Frequency

Business entities can distribute their dividends at any time they choose. However, most companies choose to pay dividends in regularly predetermined intervals – annually, semi-annually, quarterly or monthly. Most companies and equities will distribute their dividends quarterly. This frequency is convenient since it aligns with the timing of the quarterly financial result releases. The semi-annual frequency is often used by European companies for their dividend distributions. Many mutual funds use annual distributions. The companies and equities use the monthly distribution frequency to attract investors who are seeking steady monthly income payments, such as retirees or people who derive most of their income solely from investments.

Important Dividend Distribution Dates

There are four important dates in the dividend distribution process that all investors must know and understand. While certain dates are set in a specific relation to other dates and determine eligibility for receiving dividend distributions for any period, other dates are completely arbitrary.

Declaration Date is the date when the company announces the specific details about the upcoming dividend to the public. The declaration announcement contains the dividend amount that will be paid to eligible shareholders, as well as the other three important dates that follow. Since the only purpose of the dividend date is to provide information to the investors, this is the least important date of the four dates. While most companies will have individual declaration dates for each dividend period, some companies will use one declaration date to provide dividend information for the entire upcoming fiscal or calendar year.

Ex-Dividend Date is the first date when the equity’s share price is reduced by the upcoming dividend distribution amount. To be eligible for that period’s dividend distribution, investors must own the shares on the day prior to the ex-dividend date. The ex-date used to be days before the record date when companies had to manually compile the list of shareholders eligible for dividend distributions. However, with automated and electronic records of all transactions, the current requirement is that the ex-dividend date is “the first business day before the record date.”

Record Date is the date when the company compiles and verifies the shareholders of record list, which determines who will receive the upcoming dividend distribution.

Pay Date is the date when actual dividend distribution occurs. The equity sends electronic money transfers or mails the checks on the pay date.

You can find additional information on important dividend dates – especially the ex-dividend date – in this article.

Dividend Metrics

The first and most frequently quoted measure of dividend valuation is the dividend yield. Generally expressed as a percentage, the dividend yield is simple ratio of the company’s total annual dividend distribution amount and the company’s current share price. Using the actual total dividend distributions over the past year for the calculation gives us the trailing dividend yield. However, using the current period’s dividend amount to extrapolate the total annualized dividend for the upcoming year returns the forward dividend yield.

Because the dividend yield is inversely related to the equity’s share price, it can be a very unreliable indicator on its own. A sudden dividend yield increase can be a consequence of a rapid share-price drop and vice versa. Therefore, we need additional quantifiers to determine the long-term potential of a dividend distribution.

Another basic dividend measure is the Dividend Payout Ratio. The payout ratio indicates the share of a company’s net earnings that are distributed as dividends. An additional way to calculate the dividend payout ratio is to divide the annual dividends per share by the earnings per share (EPS). A payout ratio in the 30%-to-50% range is generally a sustainable level for future dividend payouts. At this level, the equity distributed a sufficient portion of its net income to generate a significant dividend income to its shareholders. However, a payout ratio in that range is not excessive to the point that it would jeopardize future dividend distributions if the company has few periods of diminished net income or reduced cash flow. This general rule does not apply to certain types of equities, such as REITs. The reason is that a REIT must, by law, distribute at least 90% of its earnings to qualify for preferred tax status.

Another important dividend metric is dividend growth. The dividend growth can be measured versus the previous year, for a period of several years or as a standard compounded annual growth rate (CAGR). This metric is important because a dividend distribution that does not grow is subject to diminished returns due to inflation and declining yields because of share-price growth.

This article should help to demystify the question, “What are dividends?” The basic definition of dividends providing the distribution of an asset to shareholders is simple and straightforward. However, despite the simple definition, dividend distributions involve many nuances. For further information and articles on dividend investing and dividend-paying equities recommendations, go to www.DividendInvestor.com. Additionally, you can start your own research for dividend-paying stocks that fit your investment portfolio strategy by taking a quick video tour of our custom tools suite.

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