What is Dividend in Stock Market?
Created on 23 Mar 2021
Wraps up in 5 Min
Read by 3.1k people
Updated on 15 Nov 2021
Remember.. back in our school days, we were taught about the factors of production. Feels nostalgic, right? As in land, labour, capital, and entrepreneurs. And they get returns in the form of rent, wages, interest, and profit correspondingly. So, the profit given to the entrepreneur is called the dividend.
Dividends are the payments made by the company to share profits with its shareholders. They are one of the ways investors earn a return from investing in the stock market. Dividends can be paid out as cash or in the form of additional shares. And announcements of it are generally accompanied by a proportional increase and decrease in share price.
In this article, let's understand everything about dividends.
Dividend: Shareholder's Reward
In simple words, dividend is the reward given by a company to its shareholders. It is distributed from the profits of the company, after meeting all expenses. That is why shareholders are also known as residual owners, i.e., they are given whatever is leftover. But companies don't distribute the entire profits as dividends and keep some portion of profits as reserves for the future. The Board of Directors decides the rate of dividend, which is approved by the shareholders.
If you think that cash is the only way to pay dividends, you are wrong! Besides it, there are other ways as well, which are as follows:
- Physical Assets: Although rare, some companies give their assets or investments to investors. Imagine how wonderful it would be to get pizzas as dividends from Jubilant Foodworks Ltd (parent company of Domino's Pizza)!
- Stocks: Companies could also issue bonus shares as dividends. But the Companies Act prohibits the companies from doing so. However, they can issue bonus shares over and above the dividend declared.
How Is Dividend Policy Decided?
Do you think that it is easy for a company to decide how much dividend to pay? DEFINITELY NOT! The Board of Directors have to consider the following factors before declaring the dividend:
- Stability of Dividends and Earnings: Usually, the companies try to maintain a stable rate of dividend. Also, a company having steady earnings is in a position to pay more dividends.
- Liquidity: Although a company earns good profits, it chooses not to declare dividends if it is illiquid. It will be unwise for a company to borrow to pay dividends. In this case, companies offer bonus shares.
- Dividend Policy of Competitors: Companies in the same industry try to follow the same dividend policy. If the competitors are paying more dividends, the investors will prefer them.
- Expansion Plans: If a company has high growth potential, it will keep more reserves to finance its growth. On the other hand, a saturated company offers more dividends due to lower growth prospects.
- Taxation Policy: Previously, companies had to pay tax on the dividend declared. But, the government abolished the Dividend Distribution Tax in FY 2020. So companies can pay more dividends without worrying about paying taxes to the government.
How to Calculate Dividend Income?
Usually, companies give dividends based on the face value of their shares. So don't be misled when you read that companies announce a dividend of 100%. They will be paying only Rs. 10 per share, not 100% of the prevailing share price! Only Majesco took it seriously and declared a dividend of Rs. 974 per share, which was even more than its share price!
From the point of view of investors, the dividend is calculated by the dividend payout ratio. Here, the dividend declared is divided by the net profits of the company. The companies which don't announce any dividends have a dividend payout ratio of 0%. It is a good option if the company is planning to expand its business. But it may be seen negatively by some investors, who invested for the sake of dividend.
Another way to calculate dividends is the retention ratio. It is complementary to the dividend payout ratio. It is computed by dividing the retained earnings by the net profit of a company.
These ratios help in understanding the financial goals of the company. If the company is declaring lower dividends, it is beneficial for future prospects. Companies paying hefty dividends generally indicate a lack of future plans. However, not necessarily so.
Financial Effect of Dividend
Rather than being an expense, dividend is an appropriation of income. It has the following effect on the financial statements of a company:
- In the Balance Sheet, it reduces the overall reserves and the aggregate cash balance with the company.
- In the Cash Flow Statement, it is an outflow under Financing Activities.
- It's not an expense and thus is not shown in the Income Statement.
Impact on Share Prices
Paying dividends may not affect the value of the company. But it has a recognizable impact on the share price. When a company declares a dividend, its share price increases with the amount of dividend declared. It is so because investors will be able to get dividends by buying the shares. But the price falls by the same proportion after the date of being eligible for getting dividend is expired, also called the record date.
Sometimes, the increase in price exceeds the amount of dividend declared. Hence, it leads to a net increase in the share price.
How to Identify Dividend Stocks?
There are more than 5000 stocks listed on BSE. Isn't it enormous? So, there are different kinds of shares traded.
Some stocks are called Dividend stocks. These stocks give most of their profits as dividends regularly. They should be in your investment portfolio. They help in earning passive income, while other stocks can help in capital appreciation. Some examples of dividend stocks are Real Estate Investment Trusts (REITs) and PSUs having substantial assets.
Let's understand how to identify these cash cows:
- The stock should have a dividend payout ratio of at least 50%.
- Dividends yield should be between 3-6%.
- The company should pay dividends regularly.
- Earning Per Share (EPS) should also increase consistently.
- Besides dividends, capital appreciation should also be taken into account.
- Lastly, the P/E Ratio should also be analyzed.
Dividend is the reward for the shareholder for taking the risk to invest in a company. Generally, it is paid in cash. But it can be paid in the form of assets as well. It is announced based on the face value of a share. But it can be calculated by computing the dividend payout ratio and the retention ratio. It is not an expense but an allocation of profit only.
On declaring dividends, the share price first rises and then falls proportionately. Dividend stocks are a good pick for your portfolio as a source of passive income. They pay significant profits as dividends regularly and have a high dividend yield.
In the end, we want to tell you that you should always evaluate your investment objectives and risk appetite before investing. Don't jump in to invest in a particular stock based on some mere enticing factors. Because-- "Half knowledge is dangerous."
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