What do dividends mean? A dissection of all Dividends could do for you

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“What’s the definition of dividends?” was the first question I remember asking my finance teacher in college the moment she said stocks and shares yield dividends. 

Dividends are reward distributions from a company's earnings to a group of shareholders, determined by the board of directors. As long as shareholders own the stock before the ex-dividend date, shareholders of dividend-paying companies will continue receiving dividends.

Normally, an investor who invests in shares receives dividend income. Some mutual funds also invest in these shares and hence, investors who have invested in these mutual funds also receive dividends. Dividends received are a type of income; therefore, many of you will ask whether you will have to pay tax on them. Yes, you will have to.

Dividends: Why and How Are They Paid?

Paying dividends is a way of appreciating the investors for their support by trusting them with their money and the dividends also act as a way to incentivise the investors to continue supporting the company.

Paying dividends at regular intervals in a consistent manner is often perceived by investors as a sign of strength and prosperity and that the management of the company has positive expectations for the company's growth.

On the flip side, companies don’t necessarily have to pay dividends. Normally, startups and a lot of smaller companies do not pay dividends because the excess profits are often flushed back into the company for growing the business. Many well-established companies also do not pay at times since they may require the excess amount to acquire other businesses or expand to other locations. So there’s no guarantee that any company will offer a dividend.

Types of dividends

A company that pays dividends is a financially healthy one with promising growth in the future. Companies paying such dividends can pay shareholders in different forms. Based on the frequency of declaration, the company can pay

  • Special dividends

often paid when the company makes substantial profits over the years. They are distributed only if the company feels they do not need the cash now or in the near future.

  • Preferred dividends - these are paid to preferred stock owners and accrues a fixed amount of returns. They are earned on shares that act more like bonds.

Besides these, below are the most common type you will come across

  • Cash - Almost all companies prefer to pay their shareholders in cash. The amount is transferred electronically or in some cases, through a cheque.
  • Stocks - Also a popular method, some companies issue new shares as dividends. The shares are issued on a pro-rata basis depending on the number of shares held.

Types of dividend policies

While there are different types of dividends paid to shareholders, companies follow different patterns of paying dividends and that depends on the type of policy chosen by them. There are four types of dividend policy

  • Stable dividend policy - This involves companies paying dividends consistently regardless of the profit fluctuations. The dividend amount will not change even if the company goes into a loss.
  • Regular dividend policy - in this case, the company fixes a certain percentage of the dividend to be paid out of the profits. So, if the profits are high, the dividend is also high and if the profits are low, the dividend is also low.
  • Irregular dividend policy - this is a case where the company decides when it wants to declare dividends. Sometimes they may use the extra amount to fund their expansions or internal projects.
  • No dividend policy - as the name says, companies do not indulge in distributing dividends. Often seen in most growth-oriented companies, this may have an impact on investors looking for long-term sustainable income.

Dividend formula and calculating dividends

Lots of people invest with the agenda of earning dividends apart from the profit of selling the shares and investors in dividend-paying stocks look for a high dividend yield. Also, the stock price of dividend-paying companies will move the most when paying dividends is around the corner. Let’s understand dividend yield with an example -

A company does well and has announced annual dividend distributions for the shareholders. For easy calculation purposes, let’s assume the dividend is ₹7 per share. If the share price of the company is ₹100, then the dividend yield is 7% (annual dividend/price per share). In reality, the numbers are much higher, which is why a dividend yield calculator is preferred for calculating.

Another common terminology used to calculate dividends is dividend payout. A dividend payout ratio (DPR) is used to find out how much percent a company pays to its investors and how much they retain for its own use. It’s pretty easy to calculate and you can use the formula below to calculate.

DPR = DP/NI

DP = Dividend Paid

NI = Net Income

The dividend payout ratio is also useful in checking sustainability. Companies with a steady dividend payout indicate a strong financial standing whereas if a company with a payout ratio of more than 100% shows that it is paying off more than what shareholders are earning.

How do dividends work?

The decision to distribute dividends is taken by the board members of the company and the process is straightforward

  • The company (publicly listed companies) generates substantial income and accumulates a significant share of retained earnings.
  • The management of the company decides if they want to retain the earnings or distribute them to the shareholders
  • The board members then get the approval of major shareholders and then declare dividends on the company’s shares
  • The dates related to the dividends are announced
  • Shareholders eligibility to earn the dividend is checked
  • The dividend amount is transferred to the shareholders 

Why should you invest in dividend stocks?

Even though dividend stocks do not have any higher growth potential than growth stocks, they can increase in value over time.

When investors invest in dividend stocks, they enjoy the benefits of value appreciation and regular income.

They also offer Dual Benefits To Investors.

  • The dividends can be reinvested.
  • Dividends can be used for personal expenses or reinvested if dividends are received by an investor.
  • The use of dividend payouts to reinvest in the same stocks can help investors earn steady returns on their investments with compounded dividends.
  • By reinvesting dividends continuously into the stock market, investors are able to boost returns.

 To wrap it up 

Investing in stocks requires an investor to consider a company's dividend policy and dividends. The dividend payment policy of an organization reflects its performance, and dividends provide investors with a high return on their investments. Earning dividends through stocks is not the only source as you can also earn dividends through mutual funds that have investments in dividend paying stocks. The AMC (Asset Management Company) in this case adds it to the Net Asset Value of the fund.

And to help you choose the top performing funds, Fi serves as an extremely friendly and easy-to-use app where you can explore options and decide on the mutual fund investment options best suited for you. With a bit of investing experience, I’m clear in understanding the meaning of dividends rather than mugging it up back in the day.

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