Dividend

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A dividend is a distribution of profits by a corporation to its shareholders. [1] When a corporation earns a profit or surplus, it is able to pay a proportion of the profit as a dividend to shareholders. Any amount not distributed is taken to be re-invested in the business (called retained earnings). The current year profit as well as the retained earnings of previous years are available for distribution; a corporation usually is prohibited from paying a dividend out of its capital. Distribution to shareholders may be in cash (usually a deposit into a bank account) or, if the corporation has a dividend reinvestment plan, the amount can be paid by the issue of further shares or by share repurchase. In some cases, the distribution may be of assets.

Contents

The dividend received by a shareholder is income of the shareholder and may be subject to income tax (see dividend tax). The tax treatment of this income varies considerably between jurisdictions. The corporation does not receive a tax deduction for the dividends it pays. [2]

A dividend is allocated as a fixed amount per share with shareholders receiving a dividend in proportion to their shareholding. Dividends can provide stable income and raise morale among shareholders. For the joint-stock company, paying dividends is not an expense; rather, it is the division of after-tax profits among shareholders. Retained earnings (profits that have not been distributed as dividends) are shown in the shareholders' equity section on the company's balance sheet the same as its issued share capital. Public companies usually pay dividends on a fixed schedule, but may declare a dividend at any time, sometimes called a special dividend to distinguish it from the fixed schedule dividends. Cooperatives, on the other hand, allocate dividends according to members' activity, so their dividends are often considered to be a pre-tax expense.

The word "dividend" comes from the Latin word "dividendum" ("thing to be divided"). [3]

History

Replica of an East Indiaman of the Dutch East India Company/United East Indies Company (VOC). The Dutch East India Company (VOC) was the first recorded publicly traded company to pay dividends. As Jeffrey Huston (2015) notes, "the origins of practices that comprise modern dividend policy can be traced chiefly to the early seventeenth century and the Dutch East India Company." Vereenigde Oostindische Compagnie spiegelretourschip Amsterdam replica.jpg
Replica of an East Indiaman of the Dutch East India Company/United East Indies Company (VOC). The Dutch East India Company (VOC) was the first recorded publicly traded company to pay dividends. As Jeffrey Huston (2015) notes, "the origins of practices that comprise modern dividend policy can be traced chiefly to the early seventeenth century and the Dutch East India Company."

In financial history of the world, the Dutch East India Company (VOC) was the first recorded (public) company ever to pay regular dividends. [6] [7] The VOC paid annual dividends worth around 18 percent of the value of the shares for almost 200 years of existence (1602–1800). [8]

Forms of payment

Cash dividends are the most common form of payment and are paid out in currency, usually via electronic funds transfer or a printed paper check. Such dividends are a form of investment income of the shareholder, usually treated as earned in the year they are paid (and not necessarily in the year a dividend was declared). For each share owned, a declared amount of money is distributed. Thus, if a person owns 100 shares and the cash dividend is 50 cents per share, the holder of the stock will be paid $50. Dividends paid are not classified as an expense, but rather a deduction of retained earnings. Dividends paid does not appear on an income statement, but does appear on the balance sheet.

Different classes of stocks have different priorities when it comes to dividend payments. Preferred stocks have priority claims on a company's income. A company must pay dividends on its preferred shares before distributing income to common share shareholders.

Stock or scrip dividends are those paid out in the form of additional shares of the issuing corporation, or another corporation (such as its subsidiary corporation). They are usually issued in proportion to shares owned (for example, for every 100 shares of stock owned, a 5% stock dividend will yield 5 extra shares).

Nothing tangible will be gained if the stock is split because the total number of shares increases, lowering the price of each share, without changing the market capitalization, or total value, of the shares held. (See also Stock dilution.)

Stock dividend distributions do not affect the market capitalization of a company. [9] [10] Stock dividends are not includable in the gross income of the shareholder for US income tax purposes. Because the shares are issued for proceeds equal to the pre-existing market price of the shares; there is no negative dilution in the amount recoverable. [11] [12]

Property dividends or dividends in specie (Latin for "in kind") are those paid out in the form of assets from the issuing corporation or another corporation, such as a subsidiary corporation. They are relatively rare and most frequently are securities of other companies owned by the issuer, however, they can take other forms, such as products and services.

Interim dividends are dividend payments made before a company's Annual General Meeting (AGM) and final financial statements. This declared dividend usually accompanies the company's interim financial statements.

Other dividends can be used in structured finance. Financial assets with known market value can be distributed as dividends; warrants are sometimes distributed in this way. For large companies with subsidiaries, dividends can take the form of shares in a subsidiary company. A common technique for "spinning off" a company from its parent is to distribute shares in the new company to the old company's shareholders. The new shares can then be traded independently.

Dividend coverage

The most popular metric to determine the dividend coverage is the payout ratio. Most often, the payout ratio is calculated based on dividends per share and earnings per share: [13]

Payout ratio = dividends per share/earnings per share × 100

A payout ratio greater than 100 means the company is paying out more in dividends for the year than it earned.

Dividends are paid in cash. On the other hand, earnings are an accountancy measure and do not represent the actual cash-flow of a company. Hence, a more liquidity-driven way to determine the dividend's safety is to replace earnings by free cash flow. The free cash flow represents the company's available cash based on its operating business after investments:

Payout ratio = dividends per share/free cash flow per share × 100

Dividend dates

A dividend that is declared must be approved by a company's board of directors before it is paid. For public companies, four dates are relevant regarding dividends: [14]

Declaration date — the day the board of directors announces its intention to pay a dividend. On that day, a liability is created and the company records that liability on its books; it now owes the money to the shareholders.

In-dividend date — the last day, which is one trading day before the ex-dividend date, where shares are said to be cum dividend ('with [including] dividend'). That is, existing shareholders and anyone who buys the shares on this day will receive the dividend, and any shareholders who have sold the shares lose their right to the dividend. After this date the shares becomes ex dividend.

Ex-dividend date — the day on which shares bought and sold no longer come attached with the right to be paid the most recently declared dividend. In the United States and many European countries, it is typically one trading day before the record date. This is an important date for any company that has many shareholders, including those that trade on exchanges, to enable reconciliation of who is entitled to be paid the dividend. Existing shareholders will receive the dividend even if they sell the shares on or after that date, whereas anyone who bought the shares will not receive the dividend. It is relatively common for a share's price to decrease on the ex-dividend date by an amount roughly equal to the dividend being paid, which reflects the decrease in the company's assets resulting from the payment of the dividend.

Book closure date — when a company announces a dividend, it will also announce the date on which the company will temporarily close its books for share transfers, which is also usually the record date.

Record dateshareholders registered in the company's record as of the record date will be paid the dividend, while shareholders who are not registered as of this date will not receive the dividend. Registration in most countries is essentially automatic for shares purchased before the ex-dividend date.

Payment date — the day on which dividend cheques will actually be mailed to shareholders or the dividend amount credited to their bank account.

Dividend frequency

Typical dividend frequencies for different countries shown in a dividend calendar. International dividend frequencies.png
Typical dividend frequencies for different countries shown in a dividend calendar.

The dividend frequency describes the number of dividend payments within a single business year. [15] Most relevant dividend frequencies are yearly, semi-annually, quarterly and monthly. Some common dividend frequencies are quarterly in the US, semi-annually in Japan and Australia and annually in Germany.

Dividend-reinvestment

Some companies have dividend reinvestment plans, or DRIPs, not to be confused with scrips. DRIPs allow shareholders to use dividends to systematically buy small amounts of stock, usually with no commission and sometimes at a slight discount. In some cases, the shareholder might not need to pay taxes on these re-invested dividends, but in most cases they do.

Dividend taxation

Most countries impose a corporate tax on the profits made by a company.

Most jurisdictions also impose a tax on dividends paid by a company to its shareholders (stockholders). The tax treatment of a dividend income varies considerably between jurisdictions. The primary tax liability is that of the shareholder, though a tax obligation may also be imposed on the corporation in the form of a withholding tax. In some cases the withholding tax may be the extent of the tax liability in relation to the dividend. A dividend tax is in addition to any tax imposed directly on the corporation on its profits. Some jurisdictions do not tax dividends.

A dividend paid by a company is not an expense of the company.

Australia and New Zealand

Australia and New Zealand have a dividend imputation system, wherein companies can attach franking credits or imputation credits to dividends. These franking credits represent the tax paid by the company upon its pre-tax profits. One dollar of company tax paid generates one franking credit. Companies can attach any proportion of franking up to a maximum amount that is calculated from the prevailing company tax rate: for each dollar of dividend paid, the maximum level of franking is the company tax rate divided by (1 - company tax rate). At the current 30% rate, this works out at 0.30 of a credit per 70 cents of dividend, or 42.857 cents per dollar of dividend. The shareholders who are able to use them, apply these credits against their income tax bills at a rate of a dollar per credit, thereby effectively eliminating the double taxation of company profits.

India

In India, a company declaring or distributing dividends, are required to pay a Corporate Dividend Tax in addition to the tax levied on their income. The dividend received by the shareholders is then exempt in their hands. Dividend-paying firms in India fell from 24 per cent in 2001 to almost 19 per cent in 2009 before rising to 19 per cent in 2010. [16] However, dividend income over and above 1,000,000 shall attract 10 per cent dividend tax in the hands of the shareholder with effect from April 2016.

United Kingdom

Dividends from UK companies are paid out of profits after corporation tax (corporation tax is at from 1 April 2017[ needs update ] – split periods are pro-rated). Dividend income is taxable on UK residents at the rate of 7.5% for basic rate payers, 32.5% for higher rate tax payers and 38.1% for additional rate payers. The income tax on dividend receipts is collected via personal tax returns. The first £2,000 of dividend income is not taxed, however dividend income above that amount is subject to the rate that would have applied if the £2,000 exemption had not been given. UK limited companies do not pay tax on dividends received from their investments or from their subsidiaries. This is classed as "franked investment income".

United States and Canada

The United States and Canada impose a lower tax rate on dividend income than ordinary income, on the assertion that company profits had already been taxed as corporate tax.

Effect on stock price

After a stock goes ex-dividend (when a dividend has just been paid, so there is no anticipation of another imminent dividend payment), the stock price should drop.

To calculate the amount of the drop, the traditional method is to view the financial effects of the dividend from the perspective of the company. Since the company has paid say £x in dividends per share out of its cash account on the left hand side of the balance sheet, the equity account on the right side should decrease an equivalent amount. This means that a £x dividend should result in a £x drop in the share price.

A more accurate method of calculating this price is to look at the share price and dividend from the after-tax perspective of a share holder. The after-tax drop in the share price (or capital gain/loss) should be equivalent to the after-tax dividend. For example, if the tax of capital gains Tcg is 35%, and the tax on dividends Td is 15%, then a £1 dividend is equivalent to £0.85 of after-tax money. To get the same financial benefit from a capital loss, the after-tax capital loss value should equal £0.85. The pre-tax capital loss would be £0.85/1 − Tcg = £0.85/1 − 0.35 = £0.85/0.65 = £1.31. In this case, a dividend of £1 has led to a larger drop in the share price of £1.31, because the tax rate on capital losses is higher than the dividend tax rate.

Finally, security analysis that does not take dividends into account may mute the decline in share price, for example in the case of a Price–earnings ratio target that does not back out cash; or amplify the decline, for example in the case of Trend following.

Criticism

Some believe that company profits are best re-invested in the company: research and development, capital investment, expansion, etc. Proponents of this view (and thus critics of dividends per se) suggest that an eagerness to return profits to shareholders may indicate the management having run out of good ideas for the future of the company. Some studies, however, have demonstrated that companies that pay dividends have higher earnings growth, suggesting that dividend payments may be evidence of confidence in earnings growth and sufficient profitability to fund future expansion. [17]

Taxation of dividends is often used as justification for retaining earnings, or for performing a stock buyback, in which the company buys back stock, thereby increasing the value of the stock left outstanding.

When dividends are paid, individual shareholders in many countries suffer from double taxation of those dividends:

  1. the company pays income tax to the government when it earns any income, and then
  2. when the dividend is paid, the individual shareholder pays income tax on the dividend payment.

In many countries, the tax rate on dividend income is lower than for other forms of income to compensate for tax paid at the corporate level.

A capital gain should not be confused with a dividend. Generally, a capital gain occurs where a capital asset is sold for an amount greater than the amount of its cost at the time the investment was purchased. A dividend is a parsing out a share of the profits, and is taxed at the dividend tax rate. If there is an increase of value of stock, and a shareholder chooses to sell the stock, the shareholder will pay a tax on capital gains (often taxed at a lower rate than ordinary income). If a holder of the stock chooses to not participate in the buyback, the price of the holder's shares could rise (as well as it could fall), but the tax on these gains is delayed until the sale of the shares.

Certain types of specialized investment companies (such as a REIT in the U.S.) allow the shareholder to partially or fully avoid double taxation of dividends.

Shareholders in companies that pay little or no cash dividends can reap the benefit of the company's profits when they sell their shareholding, or when a company is wound down and all assets liquidated and distributed amongst shareholders. This, in effect, delegates the dividend policy from the board to the individual shareholder. Payment of a dividend can increase the borrowing requirement, or leverage, of a company.

Other corporate entities

Cooperatives

Cooperative businesses may retain their earnings, or distribute part or all of them as dividends to their members. They distribute their dividends in proportion to their members' activity, instead of the value of members' shareholding. Therefore, co-op dividends are often treated as pre-tax expenses. In other words, local tax or accounting rules may treat a dividend as a form of customer rebate or a staff bonus to be deducted from turnover before profit (tax profit or operating profit) is calculated.

Consumers' cooperatives allocate dividends according to their members' trade with the co-op. For example, a credit union will pay a dividend to represent interest on a saver's deposit. A retail co-op store chain may return a percentage of a member's purchases from the co-op, in the form of cash, store credit, or equity. This type of dividend is sometimes known as a patronage dividend or patronage refund, as well as being informally named divi or divvy. [18] [19] [20]

Producer cooperatives, such as worker cooperatives, allocate dividends according to their members' contribution, such as the hours they worked or their salary. [21]

Trusts

In real estate investment trusts and royalty trusts, the distributions paid often will be consistently greater than the company earnings. This can be sustainable because the accounting earnings do not recognize any increasing value of real estate holdings and resource reserves. If there is no economic increase in the value of the company's assets then the excess distribution (or dividend) will be a return of capital and the book value of the company will have shrunk by an equal amount. This may result in capital gains which may be taxed differently from dividends representing distribution of earnings.

The distribution of profits by other forms of mutual organization also varies from that of joint-stock companies, though may not take the form of a dividend.

In the case of mutual insurance, for example, in the United States, a distribution of profits to holders of participating life policies is called a dividend. These profits are generated by the investment returns of the insurer's general account, in which premiums are invested and from which claims are paid. [22] The participating dividend may be used to decrease premiums, or to increase the cash value of the policy. [23] Some life policies pay nonparticipating dividends. As a contrasting example, in the United Kingdom, the surrender value of a with-profits policy is increased by a bonus, which also serves the purpose of distributing profits. Life insurance dividends and bonuses, while typical of mutual insurance, are also paid by some joint stock insurers.

Insurance dividend payments are not restricted to life policies. For example, general insurer State Farm Mutual Automobile Insurance Company can distribute dividends to its vehicle insurance policyholders. [24]

See also

Related Research Articles

Equity (finance) difference between the value of the assets/interest and the cost of the liabilities of something owned

In finance, equity is ownership of assets that may have debts or other liabilities attached to them. Equity is measured for accounting purposes by subtracting liabilities from the value of an asset. For example, if someone owns a car worth $9,000 and owes $3,000 on the loan used to buy the car, then the difference of $6,000 is equity. Equity can apply to a single asset, such as a car or house, or to an entire business. A business that needs to start up or expand its operations can sell its equity in order to raise cash that does not have to be repaid on a set schedule.

A dividend tax is a tax imposed by a jurisdiction on dividends paid by a corporation to its shareholders (stockholders). The primary tax liability is that of the shareholder, though a tax obligation may also be imposed on the corporation in the form of a withholding tax. In some cases the withholding tax may be the extent of the tax liability in relation to the dividend. A dividend tax is in addition to any tax imposed directly on the corporation on its profits. Some jurisdictions do not tax dividends.

In accounting, book value is the value of an asset according to its balance sheet account balance. For assets, the value is based on the original cost of the asset less any depreciation, amortization or impairment costs made against the asset. Traditionally, a company's book value is its total assets minus intangible assets and liabilities. However, in practice, depending on the source of the calculation, book value may variably include goodwill, intangible assets, or both. The value inherent in its workforce, part of the intellectual capital of a company, is always ignored. When intangible assets and goodwill are explicitly excluded, the metric is often specified to be "tangible book value".

Yield (finance) financial

In finance, the yield on a security is the amount of cash that returns to the owners of the security, in the form of interest or dividends received from it. Normally, it does not include the price variations, distinguishing it from the total return. Yield applies to various stated rates of return on stocks, fixed income instruments, and some other investment type insurance products.

Treasury stock Stock which is bought back by the issuing company

A treasury stock or reacquired stock is stock which is bought back by the issuing company, reducing the amount of outstanding stock on the open market.

Preferred stock type of stock which may have any combination of features not possessed by common stock

Preferred stock is a form of stock which may have any combination of features not possessed by common stock including properties of both an equity and a debt instrument, and is generally considered a hybrid instrument. Preferred stocks are senior to common stock, but subordinate to bonds in terms of claim and may have priority over common stock in the payment of dividends and upon liquidation. Terms of the preferred stock are described in the issuing company's articles of association or articles of incorporation.

In financial markets, stock valuation is the method of calculating theoretical values of companies and their stocks. The main use of these methods is to predict future market prices, or more generally, potential market prices, and thus to profit from price movement – stocks that are judged undervalued are bought, while stocks that are judged overvalued are sold, in the expectation that undervalued stocks will overall rise in value, while overvalued stocks will generally decrease in value.

In economics and accounting, the cost of capital is the cost of a company's funds, or, from an investor's point of view "the required rate of return on a portfolio company's existing securities". It is used to evaluate new projects of a company. It is the minimum return that investors expect for providing capital to the company, thus setting a benchmark that a new project has to meet.

The retained earnings of a corporation is the accumulated net income of the corporation that is retained by the corporation at a particular point of time, such as at the end of the reporting period. At the end of that period, the net income at that point is transferred from the Profit and Loss Account to the retained earnings account. If the balance of the retained earnings account is negative it may be called accumulated losses, retained losses or accumulated deficit, or similar terminology.

A corporate tax, also called corporation tax or company tax, is a direct tax imposed by a jurisdiction on the income or capital of corporations or analogous legal entities. Many countries impose such taxes at the national level, and a similar tax may be imposed at state or local levels. The taxes may also be referred to as income tax or capital tax. Partnerships are generally not taxed at the entity level. A country's corporate tax may apply to:

Eisner v. Macomber, 252 U.S. 189 (1920), was a tax case before the United States Supreme Court that is notable for the following holdings:

The return on equity (ROE) is a measure of the profitability of a business in relation to the equity. Because shareholder's equity can be calculated by taking all assets and subtracting all liabilities, ROE can also be thought of as a return on assets minus liabilities. ROE measures how many dollars of profit are generated for each dollar of shareholder's equity. ROE is a metric of how well the company utilizes its equity to generate profits.

The ex-dividend date, also known as the reinvestment date, is an investment term involving the timing of payment of dividends on stocks of corporations, income trusts, and other financial holdings, both publicly and privately held. The ex-date or ex-dividend date represents the date on or after which a security is traded without a previously declared dividend or distribution. Usually, but not necessarily, the opening price is the last closing price less the dividend amount.

Share repurchase is the re-acquisition by a company of its own shares. It represents a more flexible way of returning money to shareholders.

A split share corporation is a corporation that exists for a defined period of time to transform the risk and investment return of a basket of shares of conventional dividend-paying corporations into the risk and return of the two or more classes of publicly traded shares in the split share corporation. Most commonly a split share corporation issues equal numbers of shares from a class of preferred shares and a class of capital or class A shares. The proceeds of the share offering are invested in conventional dividend-paying shares according to the regulations of the split share corporation. The preferred shares typically offer relatively high and secure dividend yield at a fixed coupon rate but with no expectation of capital gain by the time that the split share corporation is wound up. The capital shares often pay a dividend like the preferred shares; in addition, the capital shares offer participation in the leveraged capital gains of the underlying basket of conventional shares.

Financial ratio characteristic number

A financial ratio or accounting ratio is a relative magnitude of two selected numerical values taken from an enterprise's financial statements. Often used in accounting, there are many standard ratios used to try to evaluate the overall financial condition of a corporation or other organization. Financial ratios may be used by managers within a firm, by current and potential shareholders (owners) of a firm, and by a firm's creditors. Financial analysts use financial ratios to compare the strengths and weaknesses in various companies. If shares in a company are traded in a financial market, the market price of the shares is used in certain financial ratios.

In finance, the capital structure substitution theory (CSS) describes the relationship between earnings, stock price and capital structure of public companies. The CSS theory hypothesizes that managements of public companies manipulate capital structure such that earnings per share (EPS) are maximized. Managements have an incentive to do so because shareholders and analysts value EPS growth. The theory is used to explain trends in capital structure, stock market valuation, dividend policy, the monetary transmission mechanism, and stock volatility, and provides an alternative to the Modigliani–Miller theorem that has limited descriptive validity in real markets. The CSS theory is only applicable in markets where share repurchases are allowed. Investors can use the CSS theory to identify undervalued stocks.

Dividend policy is concerned with financial policies regarding paying cash dividend in the present or paying an increased dividend at a later stage. Whether to issue dividends, and what amount, is determined mainly on the basis of the company's unappropriated profit and influenced by the company's long-term earning power. When cash surplus exists and is not needed by the firm, then management is expected to pay out some or all of those surplus earnings in the form of cash dividends or to repurchase the company's stock through a share buyback program.

Corporate finance area of finance dealing with the sources of funding and the capital structure of corporations

Corporate finance is the area of finance that deals with sources of funding, the capital structure of corporations, the actions that managers take to increase the value of the firm to the shareholders, and the tools and analysis used to allocate financial resources. The primary goal of corporate finance is to maximize or increase shareholder value.

The Australian dividend imputation system is a corporate tax system in which some or all of the tax paid by a company may be attributed, or imputed, to the shareholders by way of a tax credit to reduce the income tax payable on a distribution. In comparison to the classical system, dividend imputation reduces or eliminates the tax disadvantages of distributing dividends to shareholders by only requiring them to pay the difference between the corporate rate and their marginal rate. If the individual’s average tax rate is lower than the corporate rate, the individual receives a tax refund.

References

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