When an investor buys the shares of a company, he becomes
owner of a part of that company. This means that he is taking a risk: if
the company fails, he loses his investment. Of course, he is compensated for
this by the fact that should the company prosper, it should become more
valuable, and hence his part of the company should be more valuable as well.
The shareholder has one problem, however: how should he unlock this profit?
He can't ask for his money back, as a shareholder doesn't have a direct
claim to the assets of the company. The shareholder will be paid in
case that a company is dissolved, but companies normally only get
dissolved after bankruptcy, and in this case, there almost never is any
money left-especially for shareholders, as they get paid last in case of a
bankruptcy. He might want to sell the share to another investor, but the
other investor also can't get his money out, and hence might not want to pay
anything for the shares.
In order to reward their investors, many companies issue a dividend. A
dividend is a payment made to the shareholders. As the
dividend is in essence the only thing a shareholder gets for being a
shareholder, the expected future dividends may be an important driver for
the long-term development of the share price. There are two main kinds of
- Cash dividend: In case of a cash dividend, the company pays a sum
for each share. For instance, I own 300 shares of A. A pays 90 eurocents
of dividend per share. Hence, I get 270 euros in my account. I may have to
pay tax over this amount of money, though.
- Stock dividend In case of a stock dividend, the company pays its
shareholders extra shares. For instance, I own 400 shares of company B.
Company B pays a stock dividend of 1 share for each 44 shares held. In this
case, I get 9 extra shares. I also have 0.09 share because of the roundoff;
normally, I either get cash for this or can pay money to buy the rest of the
partial share. It should be noted that making extra shares in this fashion
in fact costs a company nothing; the only thing that happens is that the
same capital is spread over a larger number of shares. This is similar to
a stock split. Offering only a stock dividend is in a sense a bit of a
"fake" dividend, as it still doesn't allow the shareholders to get money out
of the companies. The tax rules for stock dividend may also be different.
Sometimes, a company also allows you to choose between a stock dividend and
a cash dividend, or it may allow you to reinvest your dividend in shares of
The dividends mentioned above are typically issued once, twice, or, rarely,
more than twice a year, or not at all in case the company pays no dividend
or decides to skip its dividend. The procedure is as follows. First, the
company proposes a dividend at the general meeting of shareholders. This
proposal usually accepted. Then, a date called the ex-dividend
date is picked. Usually, this day is just after the general meeting of
shareholders. At this date, it is recorded how many shares each investor in
the company own. The shares trade normally on this day, however, the share
price is typically discounted with the value of the dividend. This makes
sense; the company just distributed money equal to the dividend to its
shareholders, and hence is strictly worth less. The shareholder now has
dividend rights, which will be converted to cash or shares at a later date,
the payment date. It is worth noting that many brokers charge you costs
for receiving dividends, and these costs can be substantial. Furthermore,
dividend rights do not accrue interest, while the cash paid does. This means
the present value of the dividends becomes slightly lower when there is a
large difference between ex-dividend and payment date.
So, dividends reward shareholders by giving them back money. However, they
make the company the shareholders own worth less; the shareholders have been
given back some of their own money! Worse, the company cannot use this money
to invest and grow. Hence, as a shareholder, getting my money back is only
good for me if I think I can make more money investing the capital elsewhere
than if it were retained by the company. However, if this were true, why
would I invest the money in the first place? According to this argument, a
company should never pay a dividend. However, this would mean a shareholder
could never get back his investment, making the shares essentially
If you were hoping for a clever solution to this catch-22, I have to
disappoint you: as far as I know, there is no clear solution. We can,
however, make the following observations:
- If a company is growing rapidly, it likely needs its capital bady in
order to grow. There is little sense in distributing it.
- A relatively mature company might have more cash than sensible ways of
investing it. In this case, it makes sense to pay a dividend. Companies that
really have too much cash tend to opt for a special dividend: This
is a (large) one-time dividend, outside of the regular dividend cycle.
These rules of thumb can be uses to see whether the dividend policy of a
company makes sense: large, stagnant companies paying no dividend are to be
avoided as investments
, as they are apparently not very
profitable. The same goes for small, growing companies paying a large
dividend, as these companies are likely to have lots of debt
easily go bankrupt
. Companies issuing large special dividends are also
suspect: if a CEO can think of no better use for large amounts of cash than
to donate them to shareholders, he is in fact saying that other companies
are more profitable than his.
It is worth noting that there is a second way in which companies can
indirectly give back money to their shareholders. Some companies, rather
than just give away money, buy back their own shares in a share buyback
program. This rids the company of excess cash, and makes sure the
assets of the company are distributed over less shareholders. This
means the profit per share goes up.
Summarizing, dividends are a way for a company to reward its
shareholders, who are in essence the investors in
the company. It is normally the only way in which shareholders are rewarded
for holding shares in the company, and hence, the prospect of future
dividend may be an important driver in the long-term development of the
share price. A disadvantage of dividends is the fact that they are being
paid for by the shareholders themselves; this is reflected by the fact that
shares usually lose value equal to the dividend after they have gone
ex-dividend. Hence, there is no hard rule on whether high dividends are a
good or a bad thing.