Knowledge Centre
Dividends
In Latin, “dividendum”, “a thing to be divided”.
At TEAM, we believe a modern, “fit for purpose” company has three fundamental decisions to make: how much to invest in the business, how much debt to manage, and how much cash to return to shareholders. The return of cash may be through share repurchases or dividends. Here, we cover dividends.
When a company generates a profit and accumulates retained earnings, those earnings can be either reinvested in the business or paid out to shareholders as a dividend.
A dividend is a value of money paid regularly by a company to its qualifying shareholders. Most are paid quarterly (four times a year), at the end of each business quarter after the company releases the financial results for the period.
In the UK, dividends are typically paid twice a year. First, as an interim dividend made before the company AGM, and usually declared with the company’s interim financial statements. Second, as a final dividend alongside the Annual Financial Statements.
The value is on a per-share basis, and paid equally to all qualifying holders of that class of share, typically, ordinary, common, preferred, etc. This is part of the Shareholder Agreement and subject to the Memorandum and Articles of Association. The Articles may prescribe that a certain class, or classes, may rank ahead of others in any dividend payment.
A dividend is a distribution of part of the company’s earnings or normal profits. However, a one-off profit, such as major exceptional events like an asset sale, may also be shared with shareholders via a special dividend.
Dividends can only be paid out of profits or retained profits or reserves. A loss-making company with no reserves cannot pay a dividend. A company cannot pay out dividends greater than its available profits from current and previous financial years (retained profits or reserves).
Dividends are a reward to investors for committing their capital to the company.
The dividend amount is decided by the Board of Directors, as is the date the dividend is paid, known as the declaration date. The final decision to pay is based on the Board’s review of the company’s Financial Statements, and confidence that the company can comfortably afford to pay it.
Investors holding qualifying shares at the close of trading on the day before the ex-dividend date will be entitled to receipt of that dividend. The ex-dividend date is determined by the relevant stock exchange rules and is usually one day after the company declares the dividend (Declaration Date), and one day before the record date. The record date is the date set by the company board by which investors must be recorded on the register to qualify for that dividend.
When an investor buys a share(s), their name does not automatically get added to the record book—this takes about three days from the transaction date. Therefore, if the date of the record is Aug. 10, you must have purchased the shares on Aug. 7 to receive a dividend. This would make Aug. 8 the ex-dividend date, as it is the date directly following the last date on which you could get a dividend.
If a share sale has not been completed by the ex-dividend date the seller on record is the one who receives the dividend. The ex-dividend date (ex-date) is important because it determines who does, and who does not, get the dividend. The fall in share price reflects the fact new shareholders are not entitled to that payment.
The result is that typically a company's shares will trade for less than the dividend amount on the ex-dividend date than they did the day before. If the market and investors are anticipating a particularly large dividend the share may already “price” that in many days before the ex-date.
Lastly the board will announce when the dividend will be paid, payment date or pay date. This is the date the dividend cheques are actually dispatched by mail or electronically. There are various types of dividend, including;
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Cash Dividend. This is the payment of actual cash from the company directly to the qualifying shareholders and is the most common type of payment. The payment is usually made electronically, but may also be paid by cheque and dispatched by mail. (see section on share classes).
The total dividend paid is a deduction from retained earnings. It is not an expense for bookkeeping purposes. The amount appears as a debit in the balance sheet. It does not feature on the income statement.
When a dividend is declared, the company debits its retained profits/earnings and credits a liability account called dividend payable. On the date of payment, the company reverses the dividend payable with a debit entry and credits its cash account for the respective cash outflow.
Dividends shrink a company's shareholders equity and cash balance by the same amount. Firms must report any cash dividend as payments in the financing activity section of their cashflow statement reflecting the cash paid away.
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Stock and Scrip. Stock dividends are paid out to shareholders by issuing new shares in the company. These are paid out pro-rata or proportional to the number of shares the shareholder already owns. Often used when a company doesn’t have the cash to pay, or wants to preserve cash, for other investments.
Stock dividends sometimes require a holding period.
Stock dividends are not taxed until the shares granted are sold.
Scrip dividends are also known as capitalisation issues or bonus issues.
Scrip dividends are often offered as an alternative to cash dividend. It is an option to receive the dividend in shares.
Both stock and scrip dividends are exempt from stamp duty and dealing charges. They are effectively a dividend reinvestment policy (DRIP) without associated expenses.
The investor must still report the cash value of the scrip dividend on his tax return like a normal cash dividend. This differs from a stock dividend in the United States, where the investor does not pay any tax on receipt of the shares and then only capital gains taxes on the stock dividend when the shares are sold.
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Asset dividend – A company may also pay out other assets such as investment securities such as shares in a subsidiary company, physical assets, and property, although this is not a common practice.
These dividends are distributed “in specie”, the Latin for “in kind”.
A company may want to pay a property dividend if it does not have enough cash at hand to pay a healthy cash dividend.
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Special dividend. Otherwise known as an extra dividend, is one that is paid outside of a company’s regular policy (i.e., quarterly, annual, etc.). It is typically non-recurring. It is usually the result of having excess cash on hand for one reason or another and is usually larger than the normal dividend, sometimes significantly.
Special dividends tend to be declared after an exceptionally strong period of earnings, the sale of a subsidiary or asset or after achieving a particular milestone. An asset sale could include an intangible asset, such as intellectual property.
A company may have a lot of cash built up on the balance sheet through retained earnings. It may decide not to reinvest that cash back into the business and choose to distribute it to shareholders. A good example of this activity was Microsoft’s special, one-time dividend of $3 a share in July 2004, valued at a total payout worth $32 billion.
A company may want to alter its capital or financial structure.
Remember: Assets = Liabilities + Shareholder Equity.
A special dividend can be used to alter a company’s capital structure by reducing shareholder equity and assets. By paying a special dividend, the company is altering the percentage of debt versus the percentage of shareholder equity used to finance the company.
Common or Ordinary. This refers to the class of shareholders (i.e., Common, or Ordinary, shareholders).
Preferred. This also refers to the class of shareholders (Preferred) receiving the payment.
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Accelerated Dividend. Is a dividend that is paid out ahead of a change in the way the dividends are treated, such as a change in the tax on dividends. The dividend payments are made early in order to mitigate the negative impact that a change in tax may bring about.
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Other. Other, less common, types of financial assets can be paid out as dividends, such as options, warrants, shares in a new spin-out company, etc.
Dividends and tax.
For the company paying: Companies pay corporation tax on profits before dividends are paid. Dividends are not a business or tax-deductible expense. The only tax advantage to a company is in cases where dividends are paid as a bonus to shareholder employees. A bonus paid through salary will attract National Insurance in the UK, and similar employer tax contributions in other tax jurisdictions.
Note: interest paid on a company’s bonds and other debt is an expense, therefore reducing the company’s net and taxable income.
For the shareholder: when a shareholder receives a cash or scrip dividend, it is treated as income and may be subject to income tax.
Dividends are effectively taxed twice. First, the company pays tax on profits and second, the shareholder when in receipt of the post-tax dividend distribution. “Double Taxation of Dividends” means that some companies decide not to pay dividends and instead reinvest the money back into the business. That reinvestment may instead enhance earnings for shareholders and consequently improve the value of the shares, potentially resulting in greater capital gain, which (typically) is more tax efficient for shareholders.
Withholding tax
Withholding, or retention tax, is an income tax paid by the payer (the company) rather than the payee (Shareholder). The tax on the dividend is thus withheld, or deducted, from the gross (tax free) dividend. There may be additional withholding tax if the payee or recipient is a resident of a different tax jurisdiction to that of the company. The withholding tax is recorded with the dividend notification.
Withholding tax is basically a tax payment on account or credit. It may be refunded when the recipient files their tax return or there may be additional tax to be paid. This withheld tax may be eligible for a tax credit in the payee’s home tax jurisdiction depending on the existence of a Tax Treaty between the two jurisdictions.
Withholding tax rates vary from country to country. They range from 0% (e.g., United Kingdom) to 35% (e.g., Switzerland). Some countries have varying withholding tax rates that apply to different types of dividend payments (e.g., dividends from privatised companies versus non-privatised companies), while many income tax treaties impose a different withholding tax rate with respect to “significant shareholders” who hold at least 5% (if not more) of the dividend-paying company. In certain countries, the length of time that the non-resident investor has held the shares of the dividend paying company can affect the withholding tax rate. In short, the rate at which withholding tax is deducted from dividends paid to non-residents can vary widely, for a variety of reasons.
As a broad rule of thumb, the withholding tax is 15% on dividends.
Most tax authorities require withholding tax to be recorded and remitted by the company within a certain period of time. The amount withheld is treated as debit. The tax is deducted at source.
Why do companies pay a dividend?
Many shareholders, or investors, expect to receive a share of any profits generated. It is a way for them to get the invested amount back over time (see dividend cover).
The payment of a dividend evidences the company’s financial health and the company’s confidence in the future health.
Paying a dividend is a clear message to other potential investors as to the future prospects and the company’s willingness to reward shareholders. This may attract new investors and drive demand for the shares and the price up.
Why companies don’t pay a dividend
A fast-growing company, or a company experiencing a downturn, may decide it more prudent to reinvest earnings into operations.
A company may look to fund new initiatives such as new manufacturing capacity, acquire other companies or pay down debt. It may be earnings enhancing not to pay a dividend.
Mature slow growing companies may look to increase their value by preserving cash or reinvesting to find growth.
A company may suspend paying a dividend because:
It is in financial trouble, has an unexpected expense or cost (lawsuit, fine, fire, etc.), wishes to fund growth, or maybe in default to preferred shareholders.
To issue dividends to ordinary or common shareholders, the company must first pay back any dividends due to preferred shareholders. In some cases, a company may be able to pay an ordinary dividend but not to pay both preferred and ordinary dividends. The company may choose to pay preferred dividends but suspend ordinary dividends or decide to suspend all dividends entirely.
However, any preferred dividends that are deferred must be paid before any ordinary dividends can be paid. Therefore, ordinary dividends may be suspended indefinitely to afford the company to pay the preferred shareholders. Companies that have to suspend preferred dividends fight an uphill battle against ever-increasing overdue payments in subsequent years. The company is in serious trouble.
Any dividend cut or suspension is usually a negative sign. A positive development would be in a case where the cut is alongside major earnings enhancing acquisition or share buyback.
How does the board decide the dividend payout?
The board will consider a number of aspects:
Opportunities. Can more value be created by reinvesting in the business rather than paying away cash? Companies with consistent high returns on capital and or low weighted average cost of capital will be less inclined to pay away large proportions of surplus profits.
Balance Sheet and Income Statement. Companies need to have adequate cash reserves to mitigate periods of economic stress. Some companies are more volatile than others. These are less likely to push high dividend payouts.
Peer group. Companies usually have near competitors in the same industry segment. If the dividend payouts are inferior this will affect the ability to raise new capital and or new investors. It could lead to a de-rating of the share price.
Investors. Companies that pay strong dividends on a regular basis tend to appeal to wealthier, more stable investors such as pension funds and charities. Certain investors may also be attracted to dividend issuers because they can provide downside protection, all things being equal, due to dividend support.
Major shareholder considerations. A company may have a very significant shareholder, such as the founder, that requires, or even relies on, the dividend income to support their activities (philanthropic or not).
What do dividends mean to TEAM?
At TEAM, we seek to invest on a total return basis, of which dividend income is a component.
Remember: Total return = dividend yield + share price change
At TEAM a high dividend yield alone does not make a share a great investment. A company that grows its dividend consistently, that is well covered by cash earnings (CEPS) that are growing is a good investment and at TEAM we own a number of these “dividend aristocrats”; Unilever, Procter and Gamble, J&J, Nestle and LVMH for example.
The question for TEAM is, what dividend payment strategy is appropriate? It is absolutely essential that a company has sufficient capital to pursue its strategic and growth objectives and to survive any economic or company specific challenges.
If a company doesn’t have enough capital it will end up missing on opportunities or worse fall into financial distress, even bankruptcy. A company with too much capital is denying shareholders like TEAM and TEAM’s clients the opportunity to redeploy that capital elsewhere.
At TEAM we are looking to identify companies that create true shareholder value. For TEAM the highest form of value creation is organic growth followed by acquisition growth. In both of these TEAM defines sustainable value creation as consistent and growing ROIC (return on invested capital) above WACC (weighted average cost of capital).
TEAM believes that dividends or share buy backs can be the product of return on capital below the cost of capital. In other words, a high payout ratio (see below) may indicate the company is running out of growth.
To establish whether the dividend being paid is appropriate TEAM has a basic 4 stage approach.
- Stress test the operating cash flows.
- Annalise the capital structure based on company risk profile. What is the company credit rating? What is net debt to EBITDA cover? (Altman Z and Piotroski F-score)
- Estimate surplus or deficit cash flow to shareholders by looking at operating cash flow and capital structure.
- Target what appropriate payout (dividend) or financing is needed to achieve optimal capital structure for the medium term (5 years).
If the company pays a dividend, TEAM looks at the Dividend Policy and the Policy Ratios in the context of the above. The Dividend Policy Ratios measure how much the company pays in dividend relative to its earnings and share price or company value (EV).
TEAM also analyses the 3 main dividend ratios:
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Dividend payout ratio
Dividend Payout Ratio = Total Dividends / Total Net Earnings x 100%, or
Dividend Payout Ratio = Dividend per Share (DPS) / Earnings per share (EPS) x 100%
This relationship between dividend and earnings is important to TEAM. It demonstrates how much is not being paid away versus how much is available for the company to invest. High dividend payouts leave less cash for the company and therefore have implications for cash management and liquidity leading to capital structure consequences (see above).
Mature, stable and large companies usually have higher dividend payout ratio. Companies which have growth have lower or modest dividend payout ratio. TEAM portfolios look to have a mix according to the client income distribution needs.
It should be remembered that dividends are paid out of cash, not reported earnings or earnings per share (EPS). EPS includes non-cash items such as depreciation. At TEAM we prioritize Cash earnings payout. Cash earnings per share (CEPS) defined as:
Operating Cash Flow / Diluted Number of Shares in issue
TEAM looks at below as a more relevant assessment of the sustainability of a company’s dividend:
Dividend per share / CEPS x 100%
At TEAM we do not look for an unreasonable or necessary high payout ratio for dividend’s sake. The dividend payout ratio should try to achieve a balance between short term cash flows to shareholders and future growth of the
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Dividend yield
Is the amount a company annually pays per share for the investment in that share. It is expressed as a percentage:
Dividend yield = Annual Dividend per share / share price x 100%
Note this is the gross (no tax deducted) dividend.
Assuming the dividend remains the same if the share price rises the dividend yield falls and vice versa. The dividend yield, even if attractive should not be the only consideration when evaluating an investment in the shares. A share may have a high dividend yield because the share price has fallen and may continue to fall due to other considerations such as the profitability of the company. The result may be the dividend is cut or even cancelled. “If it looks too good to be true it normally is.”
The dividend yield is an estimate of the dividend only return of an investment. It is a component of total return. However, investors use dividend yield together with dividend discount models (DDM) to help estimate or predict the future share price. DDM’s are a quantitative method of predicting a share price based on the present-day share price being worth the sum of all future dividends discounted back. See separate section on DDM.
Dividend yield is the reciprocal of dividend payout ratio.
Many investors, often those close to, or in retirement, gravitate towards high dividend yielding shares. In a zero-interest rate world this has become even more the case. For many, dividends provide a consistent and hopefully rising income stream, almost disregarding how the stock market or share price performs. But dividends can become a burden to companies at the expense of growth. Dividends can also disappear.
High dividend shares can be traps. We need to understand so much more and why?
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Dividend cover ratio (DCR)
Is the number of times a company can pay current dividends to shareholders. The most basic formula is;
DCR = Net income (EPS) / Dividend declared (DPS)
At TEAM we prefer:
DCR = CEPS / DPS
This gives how many times the dividend is covered by cash earnings.
What if a company has preferred shares that rank ahead of ordinary shares?
The formula is:
DCR = (Net income – preferred dividend payments) / Dividends paid to ordinary shares
This can also be used to determine the number of times a company can pay dividends to preferred shareholders:
DCR = Net income / Dividends paid to preferred shares
So long as the DCR is greater than 1 the company has enough earnings to pay the dividend. At TEAM we look for a DCR above 2.
A low, or deteriorating DCR, may be a sign the company profits are uncertain, and the dividend is unsustainable.
Dividends are important. Companies that increase their dividends generally receive positive stock market reactions. In fact, on average, to the extent the share prices increase 2% (see “Do Changes in Dividends Signal the Future or the Past?” by Benartzi, Michaely and Thaler). For companies announcing maiden dividends, the positive reaction from market participants is greater.
Investors interpret dividend increases as good news about the long-term future for the company’s earnings and cash flow. Evidence supports this. The drawback being investors can interpret dividend increases as a long-term commitment to higher and higher payouts. This expectation can lead to disappointment.
TEAM regards dividends as an important component to a portfolio and the management of.
Why?
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Companies that pay and grow the dividend tend to grow steadily over time and the share price follows. Over the past 93 years, US shares paying dividends returned twice the performance of the market (S&P500). Since 1926 dividends have accounted for circa half the returns made from the US market.
Dividend payouts contribute to the beneficial effects of compounding. The long-term historical dividend growth rates for US shares (S&P500) is about 5%. The current average dividend yield is approximately 2%. So, with no movement in share price for 5 years, we get the following:
Starting with $1000.00 we end up with $1115.50 for a total gain of 11.55%. This was over 5 years so average annual gain 2.31%.
Year Income Dividend Yield Yield on Cost Holdings Value 1 $20.00 2.00 2.00 $1020.00 2 $21.42 2.10 2.14 $1041.42 3 $22.96 2.21 2.30 $1064.38 4 $24.64 2.32 2.46 $1089.03 5 $26.47 2.43 2.65 $1115.50
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Dividends help evaluate the investment case for a company. Does the company have and or generate real cash? Dividends evidence this. A company consistently increasing its dividend is a clear indication that it is steadily generating profits and therefore less likely to have its financial health threatened by temporary market or economic downturns.
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Dividends help reduce overall portfolio risk and volatility. Dividend payments when reinvested provide natural cash contributions to the portfolio. These can be reinvested in the paying company or elsewhere in the portfolio. Dividend payments mitigate share price losses.
Dividend paying share perform better in bear markets. They decline significantly less than non-dividend paying shares and provide cash to reinvest at lower prices averaging down the book cost of a holding or portfolio.
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Dividends help preserve value against inflation. This is due to the link between net profit and dividends. In inflationary times companies tend to increase their goods and services consumer pricing in line with inflation. Assuming operating efficiency is maintained (net operating margin) profit and dividend payout can also increase in line.
Worthwhile read in our library is “Shareholder Yield: A Better Approach to Dividend Investing” by Mebane Faber