What are Dividends? How Do They Work?

A dividend is a reward a company gives its shareholders at regular intervals, generally from its profits. Listed companies usually pay dividends in cash and are an additional source of income for shareholders. In this article, we will understand what dividends are, how they are distributed, and a few must-know topics related to dividends. We will also discuss what you should do with dividends and how reinvesting it can accelerate your compounded returns.

What is a Dividend?

A dividend is a payment made by a company out of its earnings or accumulated profits to its shareholders. When companies distribute dividends, it gives the shareholders a proportion of their earnings. The amount paid to each shareholder depends on the number of shares they own. Dividends are declared on a per-share basis. The amount paid to each shareholder will be proportional to the number of shares held. When companies consistently pay dividends over time, it signals that the company is growing and has abundant cash.

To learn more about the highest dividend-paying stocks in India, click here.

Why Do Companies Pay Dividends?

1. Attract Investors: Most investors like to receive steady cash income in the form of dividends as it becomes a secondary source of income. Therefore, more investors will be likely to buy the company’s stock.

2. Rewarding Shareholders: Dividends also act as a reward for investors for investing and showing their faith in the company.

3. Financial Strength: Investors view dividend payments as a sign of a company’s financial strength and a sign that management has positive expectations for future earnings. This also makes the company more attractive to investors.

Do all Companies/Stocks Pay Dividends?

The decision to pay dividends is completely up to the company’s discretion. Companies are not legally required to distribute profits. It can either pay dividends from its profits or invest more into itself for business expansion. Therefore, young and growing companies typically don’t pay dividends.

Usually, only mature and established cash-rich companies pay dividends. These companies have surplus cash and maintain consistent cash flow sources. However, some mature companies can also choose not to distribute dividends if they feel that investing more to expand their business will add more value to shareholders than paying dividends. 

Types of Dividends

The two most common types of dividends are cash dividends and stock dividends.

Cash Dividends

In cash dividends, companies pay the dividend in cash. The shareholders will receive the cash directly to their registered bank accounts. 

Stock Dividends

In stock dividends, companies pay the shareholders additional shares in the company instead of cash. Stock dividends dilute Earnings Per Share (EPS). [EPS indicates a company's profitability by showing how much money a business makes for each share of its common stock].

When are Dividends Paid?

Dividends can be paid quarterly, biannually, or annually. However, most companies pay dividends every quarter. They can also pay a special dividend, which occurs outside the regular dividend frequency. The frequency of dividend payments is determined by the company's management.

Important Dividend Dates

To understand the timelines of dividend payments, there are a few dates that you should learn about:

1. Declaration Date: The day a company officially announces or communicates about the next dividend payment to its shareholders.

2. Record Date: It is the date within which a person should own the shares to be eligible for receiving dividends. The company will collect information about its shareholders as of the record date to determine eligible shareholders. If you have a stock in your holdings as of the record date, you will receive a dividend from the company.

3. Ex-Dividend Date: The ex-dividend date or "ex-date" is the day the stock starts trading without the value of its next dividend payment. Typically, the ex-dividend date for a stock is one business day before the record date, meaning that an investor who buys the stock on its ex-dividend date or later will not be eligible to receive the declared dividend. It is because of the T+1 settlement in the Indian stock market. 

4. Payment Date: The payment date is the date on which the dividend is actually paid out to shareholders.

Process of Distributing Dividends

Here's a basic outline of how a listed company distributes dividends:

Dividend Proposal and Board Approval

A company first evaluates if it is in a position to issue dividends. If yes, the company's Board of Directors will consider a dividend proposal and put it to a vote. The management considers various factors, including its future capital needs and the interest of shareholders.

Dividend Declaration

The company's board announces the dividend distribution on a specific date known as the declaration date. On this day, the company reveals the dividend amount per share and the record date.

Record Date

The record date is the date on which the company determines which shareholders are entitled to receive the dividend. Shareholders as of the record date will receive the dividend, and their names will be listed in the company's records.

Dividend Payment

The payment date is when the actual dividend is distributed to eligible shareholders. On this day, the company disburses the dividend payments. The company will deposit the dividend directly to the shareholder's bank account.

An Example of Dividend Payment

Companies always declare dividends on a per-share basis. Let’s assume that Reliance Industries Ltd (RIL) declares a dividend of ₹30 per equity share. Then, an investor holding 50 shares of RIL as of the record date will receive ₹50 for each share the investor holds.

Therefore, the investor will receive:

50 x ₹30 = ₹1,500

Why are Dividends Important?

• Some companies even offer a Dividend Reinvestment Plan or DRIP. It allows a shareholder to reinvest the dividends back into the company buying its stocks usually at a discount or zero commission.
• Studies have consistently shown that dividend-paying stocks outperform non-dividend-paying stocks during a bearish market.
• It helps protect your investment from inflation. To know more, click here.
• Dividends act as a great source of passive income.
• Depending on the amount you wish to invest, there are certain tax benefits involved in the income earned from dividends.

What are the Ratios Related to Dividends?

All investors must be aware of these two ratios to analyse the various aspects of dividends:

Dividend Payout Ratio

The dividend payout ratio represents the proportion of earnings paid out as dividends. A lower payout ratio indicates that the company retains a sizeable portion of its earnings for reinvestment or future growth, which can be positive for long-term stability. On the other hand, a high payout ratio may indicate that the company is distributing a significant portion of its profits, potentially limiting its ability to invest in growth opportunities or withstand economic downturns.

Payout Ratio = Dividends Per Share/Earnings Per Share × 100, or

Payout Ratio = Dividends Per Share/Free Cash Flow Per Share × 100

Dividend Yield Ratio

The dividend yield ratio of a share is the ratio of the annual dividend per share to the share’s market price. It evaluates the dividend amount relative to the stock price. A higher dividend yield may indicate a potentially attractive income-generating opportunity. However, the dividend yield ratio is dynamic, as the value ratio changes with the stock price. It is essential to compare the yield with industry peers and assess its sustainability. The higher the dividend yield, the better it is for the shareholder.

Dividend Yield Ratio = Cash Dividend Per Share / Market Price Per Share x 100

How Do Dividends Affect a Stock's Share Price?

The declaration and payment of dividends have a specific and predictable effect on market prices. After the ex-dividend date, the share price of a stock tends to drop by the amount of dividend declared.

For example, if a company issues a dividend of ₹5 per equity share, the share price also tends to fall ₹5.

What Should You Do With Dividends?

You can either reinvest dividends or use them for your personal expenses. However, choosing between them depends on your investment goals. Reinvesting dividends helps grow your investments exponentially faster.

Investors who only consider price appreciation overlook an important source of return: the compounding that results from reinvested dividends. Reinvested dividends are cash dividends that the investor receives and uses to purchase additional shares. In the long run, the compounding effect of reinvested dividends significantly impacts the total returns on equity securities.

For example: Between 1900 and 2016, $1 invested in US equities in 1900 would have grown in real terms to just $11.9 when taking only the price appreciation or capital gain into account. However, it would've surged to $1,402 with reinvested dividends. This corresponds to a real compounded return of 6.4% per year with dividends reinvested, versus only 2.1% per year without dividends reinvested.

Taxation of Dividends

• Until March 31, 2020 (FY 2019-20), dividends received from an Indian company were exempt from taxation. That was because the company declaring such a dividend already paid dividend distribution tax (DDT) before making payment. 
• However, the Finance Act of 2020 changed the method of dividend taxation. Going forward, all dividend received on or after April 1, 2020, is taxable in the hands of the investor/shareholder. 
• The Finance Act of 2020 also imposes a Tax Deducted at Source (TDS) on dividend distribution by companies and mutual funds on or after April 1, 2020.
• The normal rate of TDS is 10% on dividend income paid in excess of ₹5,000 from a company or mutual fund.
• The tax deducted will be available as a credit from the total tax liability of the taxpayer while filing Income Tax Returns (ITR). 
• For non-resident persons, TDS is required to be deducted at the rate of 20%.
• The act also allows the deduction of interest expense incurred against the dividend. The deduction should not exceed 20% of the dividend income received.

In conclusion, investing in dividend-paying stocks can be a great source of passive income. While investing, it is crucial to look beyond the absolute dividend values and consider other factors such as dividend payout ratios. This investing style is best suitable for people who are seeking a regular cash flow!