Thursday, October 22, 2009

Dividend Explained...

To carry on what we started with "what is a bonus share?", let's discuss dividends today.

Definition of Dividend

That part of the earnings of a corporation that is distributed to its shareholders; usually paid quarterly. When a corporation earns a profit or surplus, that money can be put to two uses: it can either be re-invested in the business (called retained earnings), or it can be paid to the shareholders as a dividend. Many corporations retain a portion of their earnings and pay the remainder as a dividend.

What's in it for me (WIIFM)?

When a company offers a dividend to its stock holders, it is taking money that could be reinvested into the company, and distributing it to shareholders as a benefit of investing in the company. Receiving a dividend is good for investors, because they get a guaranteed return on their investment in the form of the money from the dividend. A stock that returns a dividend is good as an income investment or a long term growth investment. This is because these stocks tend to remain stable, and offer a tangible monetary benefit to investors.

Dividends are usually settled on a cash basis, as a payment from the company to the shareholder. They can take other forms, such as store credits (common among retail consumers' cooperatives) and shares in the company (either newly-created shares or existing shares bought in the market.) Further, many public companies offer dividend reinvestment plans, which automatically use the cash dividend to purchase additional shares for the shareholder.

Dividend generally comprise of 3 factors:
  • Amount - the money that you are getting as dividend from a company. This is generally represented as a percentage of the face value of the share of the company. For example, Hawkins Cooker recently offered a dividend of 200% i.e. Rs 20 per share (face value being Rs 10).
  • Consistency - How often does a company offer dividends. As dividends are not guaranteed. It depends on the company if it wants to declare a dividend or wants to use the profits for some other purposes. A company that offers dividends consistently along with business growth is usually better as it is able to strike a balance between growth and share holder value.
  • Timing - This is when would the dividend come into effect. Usually termed as Record Date, this is when all the shares held by any one would be considered for dividend. The point to note is, the shares should be with you before this date. One day after this date the share is termed as ex-dividend.

High dividends is not always a sign of good management. A company that needs to reinvest should not pay out all of its accounting profits in dividends. This will cause the productive capacity of the company to diminish and the company to eventually fall into bankruptcy. This actually is a technique of "corporate vultures". They buy a large controlling position in a fine company and purposefully pay far more dividends than they should. This causes the competitive position and productive capacity of the company to falter. This all takes a long time to happen and the company can rest on its laurels for a while. It takes outside analysts a long time to figure all this out. Accounting rules offer lots of scope to obscure what's going on The company is usually able to borrow money to pay dividends for quite a while before the market refuses to offer more credit. Then the inevitable day of reckoning eventually comes, but the "vulture" has already picked the bones clean before the death throes arrive.

The moral of the story is that it "pays dividends" to analyze the dividend record and dividend policy of a company.


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