What Is A Dividend?
Dividends are typically cash distributions that companies pay out on a periodic basis from earnings to shareholders. Some companies also pay stock dividends. A few companies pay annual special dividends. Dividends are set and approved by a company’s board of directors and also approved by the shareholders.
Basics of Dividends
A dividend is paid to shareholders from net profits. The company usually retains earnings to fund ongoing operations, pay debt, fund capital expenditures or conduct a share buyback. But generally, a company may also use a portion of earnings to pay a dividend. Companies can even pay dividends when there are insufficient profits by using debt or cash on hand. This may be done to maintain a long-term track record of paying a dividend. The regular dividend is paid on a recurring periodic basis typically monthly, quarterly, bi-annually or yearly. On the other hand, a special dividend is typically non-recurring and paid in addition to a regular dividend. For example, Costco Wholesale Corporation (COST) is well-known for paying a special dividend with excess cash every few years.
A dividend payment has four parts: an announcement date, an ex-dividend date, a record date, and a payment date. The announcement date is when the dividend is announced by the company. The ex-dividend date is the day when dividend eligibility expires. A shareholder must own the stock before the ex-dividend date to receive the announced dividend. The record date is the cutoff date to determine which shareholders are eligible to receive the announced dividend. The payment date is when the company distributes the dividend to shareholders who are eligible to receive the dividend.
A dividend is cash payment to shareholders and hence impacts cash flow. The dividend payment impacts the share price by reducing it by the amount of the dividend on the ex-date.
Which Companies Pay Dividends?
Typically, large established companies with stable earnings and cash flow pay dividends. But established small-cap or mid-cap companies with similar characteristics may pay dividends. Companies in certain sectors tend to pay dividends. These include consumer staples, utilities, oil and gas, financials, healthcare. In addition, companies structured as master limited partnerships or MLPs and real estate investment trusts or REITs pay dividends since they are required to do so. Start-ups and high growth companies that do not having positive earnings or have negative cash flow typically do not pay dividends.
Why Dividends Matter to Small Investors?
Dividends are passive income based on an initial investment. A small investor can use the distribution for multiple purposes including reinvestment in the same stock, investment in another stock, spending and other purposes. Dividends are also an indicator of the financial health of the company. In general, a dividend requires a company to have positive earnings and cash. Furthermore, a company that consistently raises the dividend annually requires growing top and bottom lines. Along these lines, a dividend is known to provide roughly 43% of total returns between from 1930 to 2018.
Dividend Contribution To Total Return
Finally, and most importantly dividend payers and dividend growers tend to provide better market returns with lower volatility. According to Ned Davis Research and Hartford Funds, from 1972 – 2018, dividend growers and initiators had an average annual return of 9.62% with a beta of 0.88 and standard deviation of 15.62%. Dividend payers provided an average annual return of 8.78% with a beta of 0.94 and a standard deviation of 16.37%. This is much better than companies that do not change dividend policy, don’t pay a dividend or cut or eliminate a dividend as seen in the table below.
Average Annual Returns and Volatility by Dividend Policy