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What are Dividends and Why Do Companies Offer Them?

By: , dated January 25th, 2013

A dividend is a portion of a company’s earnings that is returned to shareholders. Dividends provide an added incentive (in the form of a return on your investment) to own stock in stable companies even if they are not experiencing much growth. Many companies — mature and young, large and small — pay a regular dividend to their stockholders.

Companies use dividends to pass on their profits directly to their shareholders. Most often, the dividend comes in the form of cash: a company will pay a small percentage of its profits to the owner of each share of stock. However, it is not unheard of for companies to pay dividends in the form of stock. Dividends can be determined by a fixed rate known as preferred dividends, or a variable rate based on the company’s latest profits known as common dividends . Companies are in no way obligated to pay dividends, although they will almost always pay them to preferred shareholders unless the company is experiencing financial troubles.

There are basically three dates to keep in mind when considering dividends. The first is the declaration date, on which the company sets the dividend payment date, the amount of the dividend, and the ex-dividend date. The second is the record date, on which the company compiles a list of all current shareholders, all of whom will receive a dividend check. For practical purposes, however, this is an obsolete date — the more important date is the ex-dividend date (literally, without dividend), which generally occurs 2 days before the record date. The ex-dividend date was created to allow all pending transactions to be completed before the record date. If an investor does not own the stock before the ex-dividend date, he or she will be ineligible for the dividend payout. Further, for all pending transactions that have not been completed by the ex-dividend date, the exchanges automatically reduce the price of the stock by the amount of the dividend. This is done because a dividend payout automatically reduces the value of the company (it comes from the company’s cash reserves), and the investor would have to absorb that reduction in value (because neither the buyer nor the seller are eligible for the dividend).

Why do some companies offer dividends while others don’t? For that matter, why do any companies offer dividends? The answer, naturally, is to keep investors happy. The companies that offer dividends are most often companies that have progressed beyond the growth phase; that is, they can no longer sustain the rate of growth commonly desired by Wall Street. When companies no longer benefit sufficiently by reinvesting their profits, they usually choose to pay them out to their shareholders. Thus regular dividends are paid out to make holding the stock more appealing to investors, a move the company hopes will increase demand for the stock and therefore increase the stock’s price.

So what is the appeal of dividends? They offer a consistent return on a low-risk investment. An investor can buy in to a company that has a stable business and stable (albeit low) earnings growth, rest easy in the knowledge that the value of his or her initial investment is unlikely to drop substantially, and profit from the company’s dividend payments. Further, as the company continues to grow, the dividends themselves may grow, providing even more value to the investor. This is one way to treat dividends; however, there are other strategies for profiting from dividends. Some investors try to “capture dividends”: they will purchase the stock right after the dividend is announced, and try to sell it for the same price after they’ve collected the dividend. If successful, the investor has received the dividend at no cost. This usually doesn’t work, because the stock price usually adjusts immediately to reflect the dividend payout, as interested buyers know the stock no longer includes the current dividend payment and they adjust the amount they’re willing to pay accordingly.

This article was brought to you by the InvestorGuide Staff Writers and Editors.

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