What are dividends?

What are dividends?

What are dividends? Dividends are payments made by a corporation to its shareholders as a way to distribute a portion of its profits. When a company earns profits, it has several options for utilizing those profits. One option is to reinvest the earnings back into the business for expansion, research and development, or other purposes. Another option is to distribute the profits to its shareholders in the form of dividends.

Dividends are typically paid out on a regular basis, such as quarterly, semi-annually, or annually. They are usually expressed as a fixed amount per share or as a percentage of the stock’s market price, known as the dividend yield. The amount of dividend a shareholder receives depends on the number of shares they own.

Dividends can be paid in cash or additional shares of stock, known as stock dividends. Cash dividends are the most common type and are directly deposited into the shareholder’s brokerage account. Stock dividends, on the other hand, involve issuing additional shares to existing shareholders based on their current holdings. This increases the total number of shares outstanding but does not change the proportional ownership of each shareholder.

Cash dividends can be categorized into two types: regular dividends and special dividends. Regular dividends are planned and anticipated in advance by the company. However, there are instances when a company decides to issue special dividends. Special dividends are typically prompted by the accumulation of substantial funds or the sale of a significant portion of the company. Unlike regular dividends, special dividends are one-time payments and do not occur on a regular basis.

Dividends are a way for companies to reward their shareholders for investing in the company. They provide a regular income stream to shareholders and are particularly appealing to investors seeking income from their investments. However, not all companies pay dividends. Growth-oriented companies, especially in the technology sector, often reinvest their profits into the business rather than distributing them as dividends. Instead, these companies focus on increasing the value of their stock through capital appreciation.

It’s important to note that dividend payments are not guaranteed. A company’s board of directors decides whether to declare and distribute dividends based on various factors, including profitability, cash flow, future growth prospects, and financial obligations. A company may choose to reduce or eliminate dividends if it faces financial difficulties or if it decides to prioritize other uses for its profits.

How dividend is linked to stock price?

To comprehend the distribution of dividends to individuals, it is necessary to grasp the concept of settlement.

When purchasing a stock, you must wait for the settlement period. For instance, if you buy a stock on Monday, you have made the payment, but you do not yet possess the stock certificate. The settlement process is required, which typically takes two business days. This is known as the T+2 settlement period, signifying that it takes two days for your name to be officially recorded on the stock certificate held by your broker. Therefore, if you make the purchase on Monday, your name will be reflected on the certificate not on Tuesday, but on Wednesday.

What are regular dividends?

Why is this important? It’s crucial because companies need to determine who should receive dividends as ownership of stocks changes hands through buying and selling. To facilitate this process, companies establish three key dates: the ex-dividend date, the record date, and the payout date.

Let’s consider a scenario where a company decides to distribute dividends to shareholders whose names appear on the certificates on Wednesday, November 20th. This means that if your name is on the certificate by the end of the day on November 20th, you will receive the dividend payment. It doesn’t matter if you owned the stock before that date; what matters is having your name on the certificate on the record date.

The payout date is when the actual dividend payment is made, which could be on November 30th or any later date specified by the company. Importantly, even if you sell your stock on November 21st or later, you will still receive the dividend payment if your name was on the certificate on the record date.

To ensure your eligibility for the dividend, you need to buy the stocks before the ex-dividend date. The ex-dividend date is the deadline after which buying the stock will not entitle you to the dividend. In this situation, the ex-dividend date falls on Tuesday, the 19th. Therefore, to have your name on the certificate on Wednesday, the 20th, and qualify for the dividend on the specified payout date, you must purchase the stock on Monday, the 18th.

One might argue that it is possible to make money by buying a stock on Monday and selling it on Tuesday, taking advantage of the ex-dividend date. The idea is that if you purchase the stock on Monday, your name gets on the certificate on Wednesday, and then it is removed on Thursday. Essentially, you would have held the stock for just one day, during which you received the dividend payment. In theory, buying before the ex-dividend date and selling on the ex-dividend date seems profitable.

However, this strategy does not actually work. Let’s consider a hypothetical scenario where the company is valued at $100 billion, and you own a stock that is trading at $10. The company decides to distribute 10% of its value as dividends, which amounts to $1 per share. If you hold the stock on Monday before the ex-dividend date and sell it on Tuesday, you will eventually receive the dividend payment.

However, here’s the catch: On the ex-dividend date, people who buy the stock will not receive the $1 dividend. also, the company’s overall value decreases by the distributed amount because that 10% no longer exists within the company; it has been paid out as dividends. As a result, the price of the stock usually drops by the dividend amount. In this case, the new stock price would be $9.

Therefore, attempting to profit from this strategy doesn’t work out in practice. If you buy the stock on Monday for $10 and sell it on Tuesday, you would typically incur a loss of $1 due to the drop in the stock price, and the dividend payment you receive would essentially offset that loss. Ultimately, there would be no significant gains or losses by engaging in this strategy.

Regular dividends do not offer traders a viable opportunity to make money consistently. This is because the announcement of regular dividends is widely known and anticipated by the market. As a result, traders are cautious and aware that the company’s value will decrease by the dividend amount. Consequently, there is little room for significant gains. While there may be instances where traders make a few cents or experience minor losses, on average, the opportunities tend to balance out, resulting in minimal overall profitability.

What are special dividends?

The only situation where traders can potentially profit from dividends is when there are special dividends. With special dividends, not everyone in the market is aware of their impending release, which can lead to mispricing and opportunities for traders.

Consider a scenario where a company decides to distribute a significant portion of itself as a special dividend. Let’s assume the company’s stock is currently trading at $46, and they announce a $3 special dividend a few weeks prior. Since not all shareholders are aware of this information or actively seeking it, there is a chance for mispricing.

If you are aware of the special dividend and the ex-dividend date is approaching on Wednesday, you can anticipate that the stock price should drop by approximately $3, bringing it to around $43. However, not all market participants are knowledgeable about the special dividend and may continue trading the stock as they did previously. This could result in buy orders at higher prices because those traders are unaware of the impending dividend.

As a trader, you can take advantage of this situation by shorting the stock at the higher price, expecting the price to eventually drop, as it typically does when special dividends are paid out. Therefore, the only way to potentially profit from dividends as a trading strategy is to actively seek out special dividends and capitalize on the mispricing opportunities they may present.

One additional aspect to be mindful of is when the record date falls on a weekend. In such cases, it is typically understood that the last business day before the weekend will be considered the record date. Similarly, if a holiday occurs, it does not count towards the two-day settlement period. Instead, two consecutive business days are taken into account for the settlement process.

Dividend.com is a recommended website to explore and gather information about dividends.