A dividend is a portion of a company’s annual earnings that it chooses to return to its existing shareholders as a reward for investing in the firm. It can also act as a “signalling mechanism” that the company is profitable and that future prospects for the business are positive.
Generally, the share price of a company will decrease by the value of the payment on the ex-dividend date (the last day on which an investor can qualify for the payment by purchasing the share).
Types of Dividend
There are typically three types of dividends:
- Ordinary
- Special
- Preferred
The first type is the most common and is paid as part of the normal course of business activity.
Special dividends, as their name implies, are one-off events and should not be considered as ongoing.
Preferred dividends are issued to holders of preferred stock, who have priority over common shareholders for dividend payments. They can be paid quarterly, semi-annually, or annually, but are at the discretion of the Board of Directors and are not mandatory.
Dividends and Trading
The larger the company and the more profitable the industry, the larger and more predictable the dividend will be.
Many investors use high-paying companies as a building block of their investment portfolios, either to generate income or by reinvesting the proceeds back into the share to increase the size of the holding, thereby compounding wealth over time (assuming the share price continues to rise).
This leaves company management in a difficult situation when recessions strike, as a dividend cut can signal trouble ahead for the business.
Oftentimes, the key to distinguishing between the two is the dividend yield and the dividend payout ratio. If both are too high, the payment may not be sustainable and may be cut.
Alternatively, sometimes fast-growing companies choose not to pay dividends, as they expect a higher long-term return from reinvesting retained earnings in future growth opportunities.
Some economic theorists argue that a company’s dividend policy is irrelevant to its share price.