What it means
A company that makes a profit can keep it, to fund growth or strengthen the balance sheet, or pay it to its owners. The dividend is the part paid out.
It is declared per share, so that a dividend of $0.48 a share on 10,000,000 shares distributes $4,800,000, and each shareholder receives it in proportion to their holding. Most companies that pay dividends do so on a regular cycle, quarterly, half-yearly or annually, with an interim dividend during the year and a final dividend after the year's results, the final usually requiring shareholder approval at the annual general meeting.
Special dividends are one-off payments outside the regular pattern, often after an asset sale or a period of unusual cash generation. The mechanics follow a fixed sequence of dates.
On the declaration date the board announces the dividend, its amount and the dates that follow, and from that point the dividend is a liability of the company. The record date is the date on which the register of shareholders is consulted to determine who is entitled.
Because share trades take time to settle, an ex-dividend date is set shortly before the record date; anyone buying the shares on or after the ex-dividend date does not receive the dividend, and the share price typically falls by about the amount of the dividend that morning, since the buyer is no longer buying the right to it. The payment date is when the cash is sent.
A scrip dividend offers shares instead of cash, and a dividend reinvestment plan uses the cash to buy more shares on the shareholder's behalf. Accounting for dividends is simple but often misunderstood.
A dividend is not an expense; it is a distribution of profit, and it reduces retained earnings within equity. Until it is declared it is not recorded at all, so a final dividend proposed after the year end is disclosed but not accrued in that year's accounts.
Once declared, the amount is a current liability until paid. Dividends paid appear in the cash flow statement as a financing outflow (or, under some frameworks, an operating outflow), and dividends received from investments are income.
The legal constraint is that dividends may only be paid from distributable profits, calculated for the paying company under company law, and directors who pay beyond that limit are personally liable. The dividend decision is a matter of policy and signalling.
A board must decide how much of each year's earnings to pay out, the payout ratio, and how much to retain, and the choice depends on the company's investment opportunities, its cash generation, its balance sheet and its shareholders' expectations. Growth companies with high returns on reinvested capital pay little or nothing; mature companies with limited opportunities pay much of their earnings out.
Because investors read dividend changes as information about the board's view of the future, boards are reluctant to cut a dividend and try not to raise it to a level they may not sustain; a progressive policy of steady increases, or a policy of paying a fixed percentage of earnings, sets expectations. A cut is usually taken as a signal of trouble and the share price falls by more than the lost income implies.
Dividends are also central to valuation and to the measurement of returns. The dividend yield, the annual dividend divided by the share price, is one of the oldest valuation measures and the starting point for income investors.
The dividend discount model values a share as the present value of its expected future dividends, and in its simplest form gives a price of next year's dividend divided by the difference between the required return and the growth rate. Total shareholder return combines dividends with price change.
And dividend cover, earnings divided by dividends, shows how much room there is for the dividend to be maintained if earnings fall. Tax treatment varies widely: some systems tax dividends at lower rates or give credits for the tax the company has already paid, others tax them as ordinary income, and the difference affects whether investors prefer dividends or buybacks.
In practice
Real-world examples.
Example
A utility pays quarterly dividends totalling $1.60 a share on earnings of $2.00, a payout ratio of 80%, and has raised the dividend every year for twenty years.
Example
A technology company with high returns on reinvested capital pays no dividend, and its board argues that shareholders are better rewarded by growth in the share price.
Example
A mining company pays a base dividend of $0.20 a share plus a variable dividend of 50% of any free cash flow above a threshold, which rose to $1.40 in a strong year and fell to nil in a weak one.
Think of it
“A dividend is like a landlord distributing rental income to property owners. If the building makes money, the owners get their share of the profits.
Formula
Calculation
Total dividend = Dividend per share x Shares in issue
Payout ratio = Dividends / Net income (or Dividend per share / Earnings per share)
Dividend cover = Net income / Dividends = 1 / Payout ratio
Dividend yield = Annual dividend per share / Share price
Retained earnings for the year = Net income minus Dividends
Dividend discount model (constant growth): Share value = Next year's dividend / (Required return minus Growth rate)
Worked example. A company with net income of $12,000,000 and 10,000,000 shares declares a dividend of $0.48 a share. Its shares trade at $24.
- Earnings per share = $12,000,000 / 10,000,000 = $1.20
- Total dividend = $0.48 x 10,000,000 = $4,800,000
- Payout ratio = $0.48 / $1.20 = 40%; dividend cover = 2.5 times
- Dividend yield = $0.48 / $24 = 2.0%
- Retained for the year = $12,000,000 minus $4,800,000 = $7,200,000
- Accounting: on declaration, debit retained earnings $4,800,000, credit dividends payable $4,800,000; on payment, debit dividends payable, credit cash. No expense is recorded
Ex-dividend. If the shares close at $24.00 the day before the ex-dividend date, they would be expected to open at about $23.52 on the ex-dividend date, all else equal, since the $0.48 has separated from the share.
Valuation. If investors require an 8% return and expect the dividend to grow at 6% a year, the dividend discount model gives a value of $0.48 x 1.06 / (0.08 minus 0.06) = $0.5088 / 0.02 = $25.44, close to the market price, which suggests the market's expectations are similar.
Sustainability. If net income fell 40% to $7,200,000, earnings per share would be $0.72 and the $0.48 dividend would be covered 1.5 times, still payable. If net income fell 70% to $3,600,000, earnings per share of $0.36 would not cover the dividend, and the board would have to decide whether to pay it from reserves and cash, or cut it.Case study
Seen in the real world.
An industrial company had paid a dividend of $1.20 a share for six years, raising it modestly each year, on earnings that had been between $1.80 and $2.20 a share. A downturn cut earnings to $0.80 a share.
The board, conscious that a cut would signal distress and that many of its shareholders were income funds, maintained the $1.20 dividend, a payout of 150% of earnings, and funded the $8,000,000 shortfall between the dividend and the cash the business generated by borrowing. The following year earnings were $0.90 and the board did the same, on the argument that recovery was near.
Recovery was not near. In the third year earnings were $0.85, the company's borrowings had risen by $20,000,000 to fund dividends, its leverage covenant was under pressure, and its lenders made clear that they would not fund a fourth year. The board cut the dividend to $0.40.
The shares fell 30% on the day, more than the arithmetic of the lost income justified, because the cut was read as confirmation that the board's earlier optimism had been wrong and because the income funds sold. Several directors observed that the share price would have fallen less had the dividend been cut in the first year, when the reason was a downturn everyone could see, rather than the third, when the reason was that the company could no longer borrow to pay it.
The board reset its policy. The regular dividend was set at a level covered at least twice by earnings in a normal year, which meant about $0.60 a share on recovered earnings of $1.50, and the policy stated explicitly that the board would consider special dividends when cash generation allowed, rather than raising the regular dividend to a level that might have to be cut. Dividend cover, and the cash the dividend required against the cash the business generated, became standing items in every board pack.
The chairman's letter to shareholders acknowledged that the company had borrowed $20,000,000 to pay dividends it had not earned, and that the money would have been better used in the business. The lesson recorded was that a dividend is a distribution of profit, and that a board which pays it from anything else is not protecting shareholders but deferring the moment they find out.
Watch out
Common mistakes.
- Treating the dividend as an expense in the income statement; it is a distribution of profit that reduces equity, and it does not affect reported profit.
- Maintaining a dividend that earnings and cash no longer cover, funded by borrowing, which defers rather than avoids the cut and usually makes the eventual fall in the share price worse.
- Buying shares just before the ex-dividend date to capture the dividend, when the share price falls by about the dividend on that date and the tax on the dividend may exceed the benefit.
Questions
People also ask.
What is the difference between an interim and a final dividend?
An interim dividend is declared by the board during the financial year, on the basis of results so far; a final dividend is proposed by the board after the year end and usually approved by shareholders at the annual general meeting. Together they make up the total dividend for the year.
Why does the share price fall on the ex-dividend date?
Because a buyer on or after that date does not receive the declared dividend, so the share is worth less by about the dividend amount. The fall is not a loss to existing holders, who receive the cash.
Are dividends better than share buybacks?
They achieve the same thing, returning cash to shareholders, by different routes. Dividends give every shareholder cash and are read as a commitment; buybacks return cash to those who sell, raise earnings per share for those who stay, and are more flexible. Tax treatment and the board's wish to signal often decide between them.
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