dividends explained

Dividends are payments that a company makes to its investors on its outstanding shares. A company pays dividends on both its common and preferred shares. Dividends are made out of a company's profit or retained earnings and the amount is set by a company's "dividend policy". Preferred shares have "preference" for dividend payments which means that dividends must be paid to preferred shareholders before any dividends are paid to common shareholders.

A company is a legal entity in its own right, a "person" under the law. One of the important innovations that allowed for capitalism was the development of joint stock companies which limited the liability of investors to their investment in a company. Before this development, a company failure meant personal financial responsibility, often leading to personal bankruptcy for company directors, officers and shareholders. This separateness of the company from the investors also meant that the company had earnings and assets in its own right. Hence the need for dividends. If a company's profits were left in the company, they were called "retained earnings". If they were distributed to shareholders, they were called "dividends". From the earliest stock exchanges, the amount of a company's dividends was an important measure of a share's value. Then, as now, investors clamoured for dividends which represented their return on investment. It is up to the Board of Directors of a company to decide how much of the profits should be distributed as dividends.

Common Share Dividends

There is no certainty to a common share dividend. A company decides what dividend it should pay on common shares each time it makes a dividend payment. A company can increase, decrease or even suspend a common share dividend as business conditions change. It is actually illegal for a company, under corporate law, to pay out more than its retained earnings and have a shareholder's deficit. Many bank and debt agreements forbid companies to pay out dividends above certain levels. Over time, as the sales and earnings of a well managed company increase, the common share dividends should increase as well.

Preferred Share Dividends

Preferred shares also pay dividends which are set in some formula at issue. A preferred share with a "fixed" dividend is known as a "fixed rate" preferred share. For example, a $25 preferred share with a 5% dividend would pay $.3125 quarterly (.05 x $25/4=.3125). This is why preferred shares are usually thought of as "fixed income" investments. Other preferred shares have floating rate dividends that move as a percentage of the prime bank lending rate, for example 80% of the Prime Rate of the Royal Bank. Some preferred shares have fixed dividends for a term and floating rate dividends thereafter and are known as "fixed-floaters". Preferred shares with dividends set as a percentage of the common dividend are known as "participating" preferred shares.

Preferred shares have "preference" and rank higher than common shares in a corporate liquidation. Their provisions usually make them "cumulative" and provide for seniority of dividend as well. This means that preferred share dividends must be paid prior to any common dividends being paid. If a preferred share dividend is missed, the dividends missed are accumulated and must be paid in full prior to any common dividends being paid.

Dividend Policy

One might think that a company should just pay all of its profits in dividends. For a modern company, things aren't this simple. Modern corporations have an ongoing economic life of their own and often make investments that take many years to complete and must eventually be replaced. The differences between corporate and individual tax rates often make it advisable for the company to retain profits instead of paying dividends to individuals but encourage financial institutions to hold the preferred shares of other corporations.

Accounting and economic profits are not easily judged. Consider a company with a single plant that makes $1 million in profit this year but needs replacement next year for $4 million. Should the company distribute the entire $1 million in profit this year as dividends? It is clear that something should be put aside for replacing the plant, but the company could always borrow to do this. Should it borrow the entire amount? The interest would be a deductible expense but a high level of debt could threaten the company in a downturn.

Consider accounting depreciation. Perhaps the profit is after an annual depreciation charge of $4 million which means that the entire $1 million profit could be distributed as dividends. The reality is that accounting depreciation rarely, if ever, actually equals economic depreciation. Companies must budget and forecast for their capital expenditures and implement financing programs that mix debt and retained earnings as a source of cash for investment purposes.

Enter taxation into the picture. In modern economies, companies are taxed in their own right. This means that they pay tax on earnings before they are distributed as dividends to shareholders. In most countries, the tax regimes take this into account. In Canada, for example, a corporation gets a tax rebate on some types of dividends that it has paid to shareholders. Canadian corporations also have a low tax rate on dividend income from other corporations, since these have already been taxed when the income was earned. Dividends between a subsidiary and a parent company are not taxed at all.

Canadian individuals also receive a "dividend tax credit" for the dividends that they have received from corporations that partially compensates them for previous taxations at the corporate level. This makes the effective tax rate on dividends 36% for the highest Canadian tax bracket, which is much lower than the tax rate on interest income of 51%. This makes for a substantial preference for dividends for a Canadian investor. Canadian money managers use a "1.3 times" rule when considering between interest and dividend income, which means dividends are multiplied by 1.3 when comparing to interest income. For example, a dividend yield of 3% is equivalent to an interest yield of 3.9% (1.3 x 3% = 3.9%).

This seems to mean that an investor should always favour dividends over interest. But we have to remind ourselves that dividend yields are generally much lower than interest yields, partially for this very reason. A common stock currently pays a dividend yield under 2% where corporate bonds are paying 6%. This means that an investor would receive $2 for every $100 invested in stock compared to $6 for every $100 invested in bonds. Even after tax, the bond investor would receive $2.94 (49% of $6) compared to $1.28 (36% of $2) for a stock investor for each $100 invested.

Confused? You should be. The complexity of the tax system in modern industrial nations keeps large armies of accountants and lawyers working at trying to understand and exploit income tax legislation.

The Importance of Dividends

Dividends are very important to the investor. Every young investment student learns of the "greater fool theory" when their professor or mentor asks whether dividends are important. If the answer is "not really, if the share price increases", the professor then goes on to explain that without eventual dividends to the investor, the share is worthless. Consider, in the extreme, the purchase of a share that guaranteed not to pay any dividends or other payouts to the holder. What would be the worth of this share to the holder? Simply, it would be a "promise not to pay". Ever. The holder might get some psychographic thrill from saying they owned the share, but they would in reality have the same claim to its assets and cashflows as anyone else. Their claim would be worthless, except if they sold it to someone who hadn't figured this out. Hence the "greater fool theory".

The annualized dividend divided by the market price of a common share is called the "dividend yield" and forms an important component of the valuation process. Even though many companies don't pay dividends, they have the potential to pay dividends in the future. If they invest their earnings in new assets which will earn future cashflows, we have a claim on these future cashflows. This is why many "growth companies" in an expanding phase don't pay dividends. The shareholders hope the company reinvests their share of profits at a high return. If the company fails to make profits on these reinvestments, they would be better to pay out the profits as dividends to shareholders who could do a better job of reinvestment on their own.

Long term studies have shown that reinvested dividends are very important to the returns that investors make. They form a very important component in securities valuation and should have a very important place in the investor's analysis of a company. Well managed and excellent companies like General Electric have a history of increasing dividends. An investor should be very wary of a company that doesn't seem to want to pay dividends. If the analysis shows the earnings are reinvested in profitable projects rather than paid in dividends, this is a very good thing. If the analysis shows the projects are unprofitable or that excessive corporate expenses have eaten up the potential dividends, this is a very bad sign. Absence of a corporate dividend with stories of the corporate jet flying the President's poodle around the globe should not be taken lightly.

High dividends is not always a sign of good management. A company that needs to reinvest should not pay out all of its accounting profits in dividends. This will cause the productive capacity of the company to diminish and the company to eventually fall into bankruptcy. This actually is a technique of "corporate vultures". They buy a large controlling position in a fine company and purposefully pay far more dividends than they should. This causes the competitive position and productive capacity of the company to falter. This all takes a long time to happen and the company can rest on its laurels for a while. It takes outside analysts a long time to figure all this out. Accounting rules offer lots of scope to obscure what's going on The company is usually able to borrow money to pay dividends for quite a while before the market refuses to offer more credit. Then the inevitable day of reckoning eventually comes, but the "vulture" has already picked the bones clean before the death throes arrive.