What are dividend payments
As per definition, dividends are a distribution of profits to eligible stockholders, proposed by the Board of Directors and approved by stockholders’ vote. It’s but a way of rewarding shareholders that put their money in the stock.
If the company doesn’t pay dividends, then it’s reinvesting the funds in the business, possibly to improve it, fuel growth or any other reason, like for example trying to accumulate funds to buy out a competitor.
Dividends may be paid in cash or in stocks, and either regularly or as a special one-time event. (More on that on the next section).
Dividends in cash aren’t necessarily based in past profits. Sometimes companies increase debt to pay dividends, meaning they’re paying dividends now out of future profits (which will be committed to repaying the bank or creditor). While a company might increase its leverage to pay dividends, it can do so up to a certain limit, beyond which could prove risky. More debt means more future cash flows are already compromised to pay back capital and interest of loans taken, and more obligations to fulfill in case of recessions or a business downturn.
It’s important for a company that started paying regular dividends to keep doing it through time, as otherwise it could be taken as a signal of financial troubles ahead, and also possibly damaging trust in management. That’s one reason why many firms pay dividends well below their current capabilities.
Why in theory dividends are neutral
Dividends – whereas paid in cash or in stock – have, in principle, a neutral effect for the stockholder.
Whether the investor gets paid a cash dividend or not, he’s still the owner of the cash generated by the business. Meaning that what you don’t get in dividend payments you should get in stock price increases. The stock is more worth the more cash the company has, because stockholders own that cash, and therefore are willing to pay for it.
When the company declares a dividend payment, it sets a record date. Registered shareholders on the record date day will be entitled to perceive the dividend (beware it might take a day to update the records), even if they sell the stock before cashing it.
Usually, the next business day is the ex-dividend date. Shareholders that bought the stock on or after the ex-dividend date will not receive the dividend payment. The stock price roughly drops by the dividend amount on the ex-dividend date, so you can’t profit by either buying or selling before or after the record or ex-dividend dates. And it makes sense, if the information is public and well known in advance, none may profit from it.
If you buy it before the record date, you pay higher for the stock, but will receive the dividend. If you buy it on or after the ex-dividend date, you buy it at a discount, but won’t be entitled to the dividend payment.
Total stockholder return should be approximately the same, whereas in dividend payments and lower price increases, or all through price increases. Nonetheless and tax considerations aside, many investors still prefer the money in their pocket rather than in the company’s.
When it comes to dividends in stock, they also have a neutral effect. The total worth of the company (Market Capitalization) is always represented by the total numbers of shares outstanding times the stock quote. If you increase the numbers of shares outstanding, the worth of each of them should be lower, to keep constant the market capitalization (the whole pizza is still the same, no matter how many portions you wish to divide it). This same principle applies to stock splits (which is like changing a dollar bill for two coins of fifty cents).
In practice, stock dividends mean you own more shares at a lower price each, retaining the same total wealth. It’s often used by companies as a tool to regulate the nominal price at which the stock trades in the market, for example if it has gone too high over time (think of Berkshire Hathaway stock as an extreme case).
Should dividends be paid?
If we go deeper and before tax considerations, the decision about whether or not a cash generating company should pay cash dividends should take into account the rates of return.
If the company has better prospects of return on investments than probably most of the stockholders, then the company should keep the cash for itself and reinvest it in the business. A high growing firm, with many potential profitable investment projects may use the cash, postponing dividends now in expectation of awarding augmented dividends in the future.
A firm that’s indebted at a not-so-low rate, may use cash generated to repay the debt as fast as possible, therefore saving interest costs on future cash flows (which also increases future dividends prospects).
A vegetative firm (i.e., low to no revenue growth) with few interest investments projects, and low debt (or even a very low interest rate one) should probably return as much cash to stockholders as reasonably possible, for them to look for their own investment opportunities (hopefully, with better returns).
Sometimes dividend payments are increased or started as a way of management to convey to the market that profits are on the rise and that they feel confident on the business capabilities.
Dividends’ tax considerations
Cash dividend payments are but one possible way of returning cash to stockholders. The other common way is by repurchasing shares.
Depending on the tax legislation of the country, net dollars get by stockholders might not be the same, because effective tax rates could be different. Say, if dividends are taxed at a higher rate than capital gains on stock sales, repurchasing would be a more tax efficient way to give cash back to owners.
How to build your own dividend policy – With any single stock
We aren’t talking about building a stock portfolio that pays a certain dividend percentage, but rather how to build your own dividend policy even with a single no dividend stock.
If you wanted to build a portfolio, you’d choose stocks that on average net you a desired percentage. Say, by combining a four percent cash dividend stock at equal parts with a no dividend stock, would net you a portfolio-weighted two percent dividend. That’s straightforward.
But that isn’t the case.
Suppose you want to own a single stock that doesn’t pay dividends (nor is planning to do so), yet you still want a desired percentage.
If you just read the why-dividends-are-neutral section, then you know that what you don’t get in dividends, you should get in price increases (at least in theory). A profitable no dividend company should show price increases more often than not.
So, if you wanted a two percent dividend on a no dividend stock, you’d sell two percent of your stock holdings each year. As long as price increases are on average at least that amount, you could do it indefinitely, without ever consuming your capital.
This method was taught in Peter Lynch books, so as far as we know, credits go to him.
A few considerations should be made. The first, you shouldn’t build a dividend so high that exceeds what the company can return on average (say, through price increases). You can’t force more profitability than there already is, otherwise, you’ll indeed be eating away your investment capital.
A second consideration is that for the method to work smoothly, the company should probably be doing splits eventually, or rounding problems could arise. If you own very expensive price stocks (once again think of Berkshire Hathaway) you might not be able to sell a desirable percentage of your holdings (i.e: if you own just ten shares, you can sell one for simulating roughly a ten percent dividend or not, but there are no in-between alternatives). Nonetheless, for most stocks you could probably do this for several years before ever getting anywhere near rounding problems.
Finally, there’re also tax considerations. Your build-your-own-dividend-policy may be taxed at a capital gains rate rather than at dividend tax rate, which may be better or worse for you, depending on tax legislation requirements in your country.