Q
If a shareholder purchases a share in a company, then they are eligible to get a percentage of the company’s profit depending on the number of shares bought, that is called a dividend.
What is a Dividend?
Monetary investments need to be done continuously to fuel the business of generating profits. These investments can be in the form of “owned capital” (funded by the owners of the business) or “shared capital”. Shared Capital is the money raised by the business from the public in the marketplace; in return for a share of company ownership or profits and is measured as the total value of shares sold.
Each share is denoted by a specific price called the share price, which changes as the shares continuously trade across multiple buyers and sellers in the marketplace called “stock exchange” and owners who purchased such shares are called “shareholders”.
A shareholder not only enjoys both the rights of having purchased a share in the business in form of the profits of the business but also participates in the discussion-making process at annual general meetings. The dividend is the profit share of a shareholder which they get in return for owning a share of the company. Investing in the shares or receiving returns as dividends can be a great way to build long-term wealth for the shareholder and also become a new income stream for some new investors.
How Do Dividends Work?
One approach for investors to earn money is by purchasing stocks, holding them for a long period, and selling them when their value has increased (known as capital gains). However, dividend payouts which are often made every quarter when a firm has a revenue surplus, are another method shareholders might get a piece of the profits.
Hence, the choice of purchasing a share in the marketplace is dependent on the profile of the company in terms of management quality, industry outlook, the company’s financials and outlook, competitive strength and the price at which it is available.
Dividends play an equally pivotal role in deciding the purchase of a share as they help to measure a reliable source of return. They can also provide a regular cash supply for the shareholder to reinvest for further growth.
The parameter that measures a reliable source of return is “dividend yield”. The dividend yield is the percentage of a company’s share price that it pays out in dividends each year. Example: If A company has INR 20.0 share price and pays INR 1.00 as Dividend value for a year then Dividend Yield is 5 % (Dividend Yield (%) = Dividend Value/ Share Price).
Therefore, when you calculate the return you have made on an investment, it should include the increase in stock price plus the dividends earned by you during the period. This is the “Total Return” on an investment.
How Are Dividends Paid?
Dividend payments depend on how profitable the company is and thus is not a direct function of the share price. The board of directors still has an option to pay out dividends, even if the market has had a rough period. As a result, shares that pay dividends are often more resistant to market volatility and share price fluctuations, plus they may be eligible for favourable tax deductions. However, not all businesses will choose to pay dividends.
Companies that have continuously paid dividends over the past few decades have often been businesses that generate stable, substantial cash flow. Therefore, a business that distributes dividends draws in investors and boosts demand for its shares. Some could decide to put their profits back into the business, or if the business produces a loss, they won’t be able to return profits to shareholders.
Additionally, dividends are also appealing to investors hoping to make money. A decrease or rise in dividend payments, however, may impact a security’s price and if corporations with a lengthy history of dividend payments lowered their dividend distributions, it would hurt the stock values of those companies.
However, businesses that have boosted their dividend distributions or implemented new dividend policies are likely to see an increase in their stock price.
A dividend payment is also viewed by investors as an indication of a company’s strength and a hint that the management has high hopes for future profits, which increases the stock’s appeal. Paying dividends communicates a strong, obvious statement about a company’s prospects and performance. Additionally, a company’s desire and capacity to pay consistent dividends over time is a strong indication of financial health.
Is it Compulsory For a Company to Pay Dividends?
A fast-growing company may choose not to pay dividends as profits would be used to fund future growth cycles while a stable-growth company may opt to pay dividends as a means to retain shareholders to keep reinvesting in the company.
Companies that decide to pay a dividend might use one of the three routes:
- Residual (dividend payments can come out of leftover equity only after all project capital requirements are met)
- Stable (companies consistently pay a dividend each year regardless of earnings fluctuations)
- Hybrid (companies establish a set dividend that is a relatively small portion but can be easily maintained even when they experience business cycle fluctuations).
The decision to choose a dividend payout route simply impacts the income stream for investors and the profitability of the company.
Thus, we can see that often growth or legacy brands resort to payout dividends to their shareholders and some companies keep profits as retained earnings to reinvest funds (rather than paying them out as dividends) as it increases the value of the company in the long-term and increases the market value.
However, companies can also offer their stakeholders a buyback option as well; which typically means it repurchases the shares by initiating a buyback program to simply reduce the number of stocks it has on the market. Share repurchases usually increase earnings-per-share (EPS), and cash-flow-per-share, and improve performance measures like return on equity.
“Dividends are like the fruits of the stock market tree, providing investors with a taste of the company’s success.”
Buvanesh
When a company seeks to boost its share price, consolidate ownership, or lower the cost of capital, a buyback may also be started. A buyback is also often a signal from the promoters to the market that the current share price is low compared to the value of the business. Depending on each individual situation as well as the tax implications, companies use either route to return money to shareholders.
Often, after the declaration of a stock dividend, there is a proportionate decrease in the stock price of the company is often noticed. The reason is, a stock dividend lowers the book value per common share while the company’s worth stays the same.
Bottom Line
A dividend can be a sustainable and secured income flow for the longer run. A trusted financial adviser with expert knowledge and access to market intelligence can help the shareholder decide on the right investments based on their risk profile.