Thursday, 22 November 2007

Dividends and Dividend Policy

If you have bought shares before, chances are, you may have received dividends. There is however companies which do not pay out dividends but simply reinvest their earning back to the companies. There are also companies which go to the market to repurchase back their own shares and there are companies which decided to perform stock splits. The question here is what will happen to the share price with each different decision made and each action taken? Let's try to understand the various ways a company can choose to exercise their decisions.

Cash dividends, as the name implies, are payments made to shareholders in cash. They come in three forms:
  1. Regular dividends occur when a company pays out a portion of profits on a consistent schedule (e.g., quarterly). A long-term record of stable or increasing dividends is widely viewed by investors as a sign of a company's financial stability.
  2. Special dividends are used when the company does not have a regular dividend schedule or if favorable circumstances allow the firm to make a one-time cash payment to shareholders. Many cyclical firms (e.g., automakers) will use a special dividend to share profits with shareholders when times are good, but maintain the flexibility to conserve cash when profits are down. Other names for special dividends include "extra dividends" and "irregular dividends."
  3. Liquidating dividends occur when a company goes out of business and distributes the proceeds to shareholders. For tax purposes, a liquidating dividend is treated as a return of capital and amounts over the investor's tax basis are taxed as capital gains.

No matter which form cash dividends take, their net effect is to transfer cash from the company to its shareholders. The payment of a cash dividend reduces a company's assets and the market value of its equity. This means that immediately after a dividend is paid, the price of the stock should drop by the amount of the dividend (theoretically).

Stock dividends are dividends paid out in new shares of stock rather than cash. In this case, there will be more shares outstanding, but each one will be worth less. Stock dividends are commonly expressed as a percentage. A 10% stock dividend means every shareholder gets 10% more stock.

Stock splits divide each existing share into multiple shares, thus creating more shares. There are now more shares, but the price of each share will drop correspondingly to the number of shares created, so there is no change in the owner's wealth. Splits are expressed as a ratio. In a 2-for-1 (US convention, Singapore convention would be 1-for-2) stock split, each old share is split into two new shares. Stock splits are more common today than stock dividends.

The bottom line for stock splits and stock dividends is that they increase the total number of shares outstanding, but because the stock price and earnings per share are adjusted proportionally, a shareholder's total wealth is unchanged.

Reverse stock splits are the opposite of stock splits. After a reverse split there are fewer shares outstanding but higher stock prices. Since these factors offset one another, shareholder wealth is unchanged. The logic behind a reverse stock split is that the perceived optimal stock price range is $20 to $80 per share in the US, and most investors consider a stock with a price less than $5 per share less than investment grade. A company in financial distress whose stock has fallen dramatically may declare a reverse stock split to increase the stock price.

There are a few dates which we need to take note of. They are,

  1. Declaration date - The date the board of directors approves payment of the dividend.
  2. Ex-dividend date - The first day a share of stock trades without the dividend. The ex-dividend date is also the cut-off date for receiving the dividend and occurs two business days before the holder-of-record date. If you buy the share on or after the ex-dividend date, you will not receive the dividend.
  3. Holder-of-record date - The date on which the shareholders of record are designated to receive the dividend.
  4. Payment date - The date the dividend checks are mailed out, or when the payment is electronically transferred to shareholder accounts.

Stocks are traded ex-dividend on and after the ex-dividend date, so stock prices should fall by the amount of the dividend on the ex-dividend date. Because of taxes, however, the drop in price may be closer to the after-tax value of dividends.

A share repurchase is a transaction in which a company buys back shares of its own common stock. Since shares are bought using a company's own cash, a share repurchase can be considered an alternative to a cash dividend. If the tax treatment for both cash dividend and share repurchase is the same, then a share repurchase has the same impact on shareholder wealth as a cash dividend payment of an equal amount.

A share repurchase using borrowed funds will increase EPS if the after-tax cost of debt used to buy back shares is less than the earnings yield of the shares before the repurchase. It will decrease EPS if the cost of debt is greater than the earnings yield, and it will not change EPS if the two are equal.

There are three ways a company can perform share repurchase. They are,

  1. Buy in the open market
  2. Buy a fixed number of shares at a fixed price
  3. Repurchase by direct negotiation

A company's dividend payout policy is the approach a company follows in determining the amount and timing of dividend payments to shareholders. Six primary factors affect a company's dividend payout policy:

  1. Signaling effect - Unexpected changes in a company's dividend policy is often viewed by investors as a signal from management about projections of the firm's future performance. In other words, stockholders perceive changes in dividend policy as conveying important information about the firm.
  2. Taxation of dividends - Investors are concerned about after-tax returns. Investment income is taxed by most countries; however, the ways that dividends are taxed vary widely from country to country. The method and amount of tax applied to a dividend payment can have a significant impact on a firm's dividend policy.
  3. Clientele effect - This refers to the varying preferences for dividends of different groups of investors, such as individuals, institutions, and corporations.
  4. Restrictions on dividend payments - Companies may be restricted from paying dividends either by legal requirements or by implicit restrictions caused by cash needs of the business.
  5. Flotation costs on new issues versus cost of retained earnings
  6. Shareholder preference for current income versus capital gains

The information conveyed by dividend initiation is ambiguous. On one hand, a dividend initiation could mean that a company is sharing its wealth with shareholders - a positive signal. On the other hand, initiating a dividend could mean that a company has a lack of profitable reinvestment opportunities -a negative signal.

An unexpected dividend increase can signal to investors that a company's future business prospects are strong and that managers will share the success with shareholders.

Unexpected dividend decreases or omissions are typically negative signals that the business is in trouble and that management does not think the current dividend payment can be maintained. In rare instances, however, management can attempt to send a positive signal by cutting the dividend. Management may believe profitable investment opportunities are available and that shareholders would ultimately receive a greater benefit by having earnings reinvested in the company rather than being paid out as dividends.

The information content in dividend policy changes is viewed differently across countries. In the US, investors infer that even small changes in a dividend send a major signal about a company's prospects. However, in Japan and other Asian countries, investors are less likely to assume that even a large change in dividend policy signals anything about a company's future. As a result, Asian companies are freer to raise and lower their dividends as circumstances change without being concerned about how investor reactions may affect the stock price.

Hope this post has provided better insight to the dividends and dividend policy used by companies. Take note that whatever discussed here is theoretical. What happen in real life when a company announced its earning and dividend payment or share repurchase can bring very different impacts to its share price based on investor sentiment. Cheers.

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