Updated on: December 26, 2022 ; Wealth & Value
What are dividends?
Dividends are payouts made to shareholders by the company either in the form of monetary payouts or additional shares issued. They can be seen as a way of distributing the income generated by the company back to its shareholders.
Consider a company named WCW Ltd. that generated an income of 10 crores in a year. And you happen to be one of the prominent shareholders in the company with 10% holdings. But you don’t hold any position in the company’s management or board of directors, so you are not eligible for any remuneration from the company.
In that case, you don’t get any income in your personal account from WCW. WCW’s income of 10 crores goes to the company’s cash reserves. It is up to the management to decide, how to utilize that money. They might decide to hold on to it, re-invest in the company or outside, repay debts, or pay back the shareholders in form of dividends.
So, if WCW’s management decides to reward its shareholders with a portion of its profits, they may do so by issuing dividends. Please note that there is no obligation on WCW’s part to issue any dividend. They may choose to refrain from issuing them for a long period or ever. I hope this makes the definition of dividends clear.
Just that you know, there are dividends paid by some specific types of mutual funds as well. But we will limit our discussion to dividends paid by companies in this article.
Different types of dividends:
There are two major types of dividends paid based on the type of shareholder.
Preferred dividend: This is given out to preferred shareholders. They get a preference in dividends over other shareholders. Also, their dividends rate are pre-determined and more regular than other classes of dividends. Their dividend rates are normally higher. So when it comes to dividends, preferred shareholders seem to fare better. But there are other downsides. We will leave that for some other time.
Special dividend: This is the other type of dividend and the more common one that is paid to the common stockholders. This is where the company’s management or board of directors decide whether the dividends have to paid out or not and how much would it be.
How are dividends calculated?
There are a few metrics and ratios related to dividends. Let us understand them one by one.
Dividend payout: This is the percentage of net income that is paid out as dividends to the shareholders. This tells us how much of the income is paid back to the investors and how much is retained by the company.
Dividend payout ratio = Dividend paid/Net income
Dividend yield: It is the return generated only in the form of dividends from a stock. It moves in the opposite direction to the stock price. Yield goes down if the stock price goes up and vice versa. The dividend vield will change as the share price moves.
Dividend yield = Annual dividends per share/Price per share
Most of the companies do not pay dividends. The dividend payout ratio and dividend yield for such cases will be zero. It does not mean that it is not a good investment. We will get to it later in this post.
Now, the most important metric that you would hear in the news is the dividend percentage announced by companies. It is very crucial to understand this number as it can be very misleading if you don’t understand actual meaning of this number. Let us look at an example to understand this.
Suppose WCW is trading at 100 rupees a share and has announced a 50% dividend. What would be your reaction? You would be elated, right? After all, for every share you own you are getting 50% dividend. But wait, does it mean 50% of 100 = 50 rupees per share? Unfortunately not!
The dividends are computed on the face value of the share and not on the market value. There is a big difference between the two. Mostly the face value of stocks is in the range of 1-10 rupees per share. So in the example above, if the face value for a share of WCW stands at 1 rupee, then the dividend per share would be just 50 paise (0.5 rupees). This amount does look as magnanimous as initially perceived.
So, next time you hear an announcement of dividends in the range of 200% or 500%, please do check the face value and then compare it with the market value.
Also there are no free lunches. The moment dividends get allotted to the shareholders, markets adjust the share price accordingly. Mr. Market is a great leveler in that way!
When are dividends paid out?
Dividends can be paid out anytime by the company. Since companies have to report quarterly results, it normally around this time when companies declare dividends, in case they plan to give any. So dividends are normally paid out quarterly, semi-annually or annually. Please note, there are no obligations to stick to any specific pattern of dividend payout. So WCW may choose to pay dividends in a quarter or a year and not pay any in the following year.
Any dividends that are paid before the Annual General Meeting(AGM) or before the close of the financial year are called interim dividends.
The dividends that are declared at the AGM, or after the close of the financial year are called final dividends.
There are a few other differences in terms of the process and revocation but they are not of much material importance.
Is there a catch?
Dividends are taxable at the shareholder’s hand. These rules keep changing. At the time of writing this article they were taxable. They are taxed at the income slab applicable to the shareholder.
What does it mean for you as an investor?
The question you might have is, Should I invest in high dividend paying stocks or focus on high growth stocks?
As explained above, dividends are profits of a company shared with the shareholders. The remaining portion of the profits is reinvested back into the company. If the company does not have a suitable plan for reinvestment and growth, then it is better they return the profit back to the shareholders. This way it is at the discretion of the shareholder to invest that amount as he/she deems suitable.
But it will take a lot of monitoring and discipline at the shareholder’s end to channel back the dividends through the right investments. Also, don’t forget that you pay additional tax on each dividend income. In case you plan to invest back the dividend received back in the same company, then you are effectively paying the tax for no good reason.
But if your intention is to extract some capital out of your investments without selling any stocks then maybe dividend-paying stocks could be more suited for you. Whatever strategy you may apply, do keep in mind that you have to invest in quality stocks.
My suggestion would be to have a portion of your diversified portfolio in high-quality dividend-paying stocks. You might want to increase the portion as you get nearer to your retirement age.
Stay invested !!!