Dividends Explained

Dividends are corporate profits distributed to shareholders. When a company makes a profit, the board of directors can decide whether to reinvest the profits in the company or to pay out a portion of the profits to shareholders as a dividend on shares. The board of directors determines the amount of the dividend on stocks, as well as the dividend payout dates.

Stockholders typically receive a certain amount of dividends per share for each share of stock they own. Tax rates on dividends, historically, have often differed from tax rates on capital gains from investments. If the dividend tax rate exceeds the capital gains tax rate, it may benefit the shareholders to avoid paying a dividend, and instead to carry out a stock repurchase.

Dividend Yield Definition

We define dividend yield as the dividend amount expressed as a percent of the current stock price. For example, if a stock will pay a \$1 dividend at the end of this year, and today the stock price is \$10, then that stock’s dividend yield is 10%.

10% = 1/10

Dividend yield equation

Dividend Yield = D1 / P0

D1 = Annual dividend per share amount (the dividend per share at time period one)
P0 = Current stock price (the price at time period zero)

Dividend Date Definitions

The process of distributing dividends to shareholders follows a set schedule. The board of directors announces the dividend on the dividend declaration date. Once the dividend has been declared, the company is legally obligated to pay the stated dividend to shareholders.

The next significant date is the ex dividend date. Investors who purchase the stock on or after the ex-dividend date will not receive the forthcoming dividend. Prior to the ex dividend date, the stock is considered cum dividend, or with dividend. This means that anyone buying the stock during this period will receive the forthcoming dividend.

The ex dividend day precedes the dividend record date, or the dividend date of record, by three days. Shareholders documented as owning the stock on the dividend record date will receive the dividend.

Last is the dividend payable date, or the dividend distribution date. This is the actual date on which the company pays out the dividends to its shareholders. The dividend payable date is typically about a month after the dividend date of record.

Dividend Payout Dates

• Dividend Declaration Date (stock is trading cum dividend)
• Ex-Dividend Date
• Dividend Record Date (three days after the ex-dividend date)
Payable Date for Dividend (one month after the dividend record date)

Dividend Signaling

Dividend signaling hypothesis refers to the idea that changes in a company’s dividend policy reflect management’s perceptions of the company’s future earnings outlook. Basically, it states that a change in a company’s dividend policy can be interpreted as a signal regarding future earnings. The problem is that a company can interpret the signals as contradictory messages.

Dividend Example

For example, if a company announces that it will increase its dividend yield, investors may interpret this as a positive signal. It could mean the company anticipates a profitable future and is allowing shareholders to benefit from these profits.

On the other hand, one can interpret an increase in the dividend payout rate as a negative signal. It could mean that the company has no good investment opportunities, and it has nothing better to do with its cash than to pay it out to shareholders as dividends.

Similarly, if a company announces that it will decrease its dividend payout rate, this can be interpreted as either a positive or negative signal. It could be interpreted as a positive signal because it could mean that the company has so many good investment opportunities that it needs all available cash for positive-NPV investments and projects. This could mean the company is growing and expanding.

On the other hand, if a company cuts its dividend rate, that could mean that the company anticipates lower earnings or even losses. This, of course, could be a bad sign. So as you can see, the logic behind the dividend signaling hypothesis makes sense, but because it can be interpreted in contradictory ways, the reading of the signals is not necessarily very meaningful.

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