A dividend is a distribution of a portion of a company’s earnings to its shareholders which can take the form of cash, stock or property.
A shareholder owning stock in a company receives a claim on any profits a company pays out in dividends. A company is not required to pay dividends and it is a decision of the Board of Directors whether they chose to do so.
As an alternative the company may chose to retain profits and reinvest in the business. The company may also decide to use its profits to purchase its own stock through a share repurchase program or reduce its debt by purchasing or retiring its bonds.
Depending on the maturity of the company, its growth prospects, and the desired impact on the stock price, the company may implement one or more of these options.
The process of paying cash dividends begins with the board of directors. The board must approve any dividends paid and the date the board announces its intention to pay dividends is called the declaration
date. The company will declare a dividend per share (DPS), meaning that for each share owned by the shareholder the company will pay a certain monetary amount.
This decision is typically based on the earnings per share (EPS), which represents the portion of the company’s earnings that is allocated to each share of stock. If a company has 100 shares outstanding, and has a net income of US$200, then the earnings per share is calculated by dividing the net income by the shares outstanding, in this case $200 divided by 100 shares outstanding or an EPS of $ 2 per share.
The dividend payout ratio (DPR) is the percentage of a company’s net income that is given to shareholders in the form of dividends. It is calculated by dividing the dividend per share by the earnings per share.
If the company decided to pay a dividend of $1 per share, the ratio would be 50 percent ($1/$2).
The next important date in the dividend payment process is the ex-date. In order to receive the dividend, a shareholder must own the stock before the ex-date. The ex-date is normally prior to the record date. The record date is the date the company uses to determine the shareholders which receive the dividend.
The records date comes after the ex-date to allow time for trades to settle. There is a time gap between the purchase of the stock, and the settlement, which is the exchange of cash and stock.
Finally, the payment date is the date the company actually pays the dividend to the shareholders of record.
Benjamin Graham, the father of Value Investing, said that the purpose of a company is to pay dividends to its owners.
Historically investors preferred stocks which offered a high dividend yield. This sentiment has changed greatly in the last 20 years as investors prefer that companies reinvest and grow their businesses, which if successful, should lead to higher stock prices.
Given the recent financial crisis, investors attitudes are gravitating back towards historical expectations.