What are Dividends and when is it rational to pay them?

Dividends

“Do you know the only thing that gives me pleasure? It’s to see my dividends coming in.” – John D Rockefeller

While the above view may sound a bit extreme, Mr Rockefeller did have a point. There is a certain joy in seeing dividends drop into your bank account (or get mailed by cheque to your address the old fashioned way). So what are these magical payments and why do companies send them to you?

Dividends are basically a portion of the company’s earnings that are distributed to its shareholders. As a shareholder, one of your legal rights is that you are entitled to receive any dividends that are declared by the company.

Timing of Payouts

Dividends are classified on when they are paid out as

  • Interim Dividends: These are declared by the Board of directors at any time before the closure of financial year and paid out during the year.
  • Final Dividends: This dividend is paid at the end of the financial year once the company’s financial statements have been prepared and audited for the entire year. Final Dividend is generally declared at an annual general
    meeting if recommended by the Board of Directors.

Noteworthy Dates 

Lets consider ITC’s final dividend payout of Rs 6.25 per share as an example. Relevant dates are mentioned in brackets

  • Declaration Date: The date on which the board of directors announces to the public that the company will be paying a dividend. (22-05-15)
  • Cum-dividend date: The day before the ex-dividend date i.e the last date on which you can buy shares and still receive a dividend (02-06-15)
  • Ex-dividend date: The date on which the company’s shares trade ex-dividend, i.e the share price drops by a proportionate amount to account for the dividend being paid out. You must buy shares before the ex-dividend date to receive a dividend. (03-06-15)
  • Record Date: The date on which the company checks its records to determine who to pay the dividend to, typically two business days after the ex-dividend date. In ITC’s case it is a final dividend where there is no Record date, instead there is a Book closure from June 5th to June 9th 2015.

If you bought shares on June 2nd (T), it will show up on June 4th evening (T+2) as                   India has a T+2 settlement system for shares, thus showing up when the company                 checks it during the book closure date

  • Payout date: The date on which you get your money. (03-08-15)

Tax Implications

Dividends from domestic companies in India are tax free in the hands of shareholders, while the company paying dividend has to pay a tax called Dividend Distribution Tax (15% excluding cess and surcharge). As of the 2014 budget, the manner of calculating DDT was changed changing the effective tax rate (including education cess of 3% and surcharge of 5%) from 16.995% to 19.99%.

Relevant metrics

(1) Dividend Payout Ratio = Dividend per Share / Earnings per Share

This ratio indicates what percentage of the company’s net earnings per share are being paid out as dividends. Check over a period of atleast 5 years because it may be abnormally high or low some years depending on certain factors like special dividends or a reduction during temporary financial troubles.

(2) Dividend yield = Dividend per Share / Current Market Price.

Always check if the dividend is sustainable while calculating this. Some companies may have abnormally high yields because their price has fallen or they are paying more dividends today than they can comfortably sustain.

(3) Yield on Cost = Dividend per Share / Average Cost per Share

This tells you the dividend yield on the investment you made. As the company increases its earnings over time, it will (hopefully) distribute more in dividends to you, therefore this will increase over time.

Capital Allocation aspects & Dividend Policy

The company’s management is the steward of the capital of its shareholders, and thus should allocate capital in a manner that will create shareholder value. To this end, it should retain earnings when it can profitably reinvest those earnings to obtain a high return on invested capital. Any earnings that it cannot employ in this manner, it has a duty to return to its shareholders. Typically, companies that are growing aggressively or require more capital for capital expenditure will pay a smaller percentage of their profit as a dividend than a mature or less capital intensive business.

A company will often state its dividend policy in its annual report (or on its website), either mentioning that it will pay a specific % of profits as dividend or otherwise mention on what basis it decides how much to pay out. Consider for example, this policy mentioned for ONGC.

Dividends are declared at the Annual General Meeting of the shareholders based on the recommendation by the Board. The Board may recommend dividends, at its discretion, to be paid to our members. The Board may also declare interim dividends. Generally, the factors that may be considered by the Board before making any recommendations for the dividend include, but are not limited to, future capital expenditure plans, profits earned during the financial year, cost of raising funds from alternate sources, cash flow position and applicable taxes including tax on dividend, subject to the Government guidelines described below:

As per the guideline dated February 11, 1998 from the Government of India, all profit-making PSUs which are essentially commercial enterprises should declare the higher of a minimum dividend of 20 percent on equity or a minimum dividend payout of 20 percent of post-tax profit. The minimum dividend pay-out in respect of enterprises in the oil, petroleum, chemical and other infrastructure sectors such as us should be 30 percent of post-tax profits

Such a policy makes it pretty clear what to expect.

Bottomline

What makes dividends especially valuable is that unlike the interest you receive from fixed income securities, dividends can potentially scale with time as the earnings of the company grow. Additionally, you have the option of reinvesting your dividends, using them to buy additional shares in the company and thus being entitled to even greater future dividends. Thus they are a way for shareholders to earn a realized return from their shareholding without selling their shares.

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8 thoughts on “What are Dividends and when is it rational to pay them?

  1. And also, a dividend is real cash that a company has to pay out…it can’t fudge the numbers or run aggressive accounting entries for the same. Cold ,hard cash paid out over several years is very tough to conjure up and is a very positive sign for an investor. An exception to this rule would be entities controlled by the Indian government.

    1. Agreed Nishanth. Looking at a history of 20 years consistent dividend payment was one of the things that Benjamin Graham recommended as a criteria for a conservative investor.

  2. I have a query here. If the share price trades minus the dividend then where is the growth. That is as good as me redeeming some shares say 2 % of my total holdings.

    Eg:
    share price before payout 1000
    Share price after payout 990 assuming 10 dividend
    Suppose i buy 0.01 share out of that 10 rs

    Yes i have 1.01 shares, but my networth is still 1000.

    So my question, whats the benefit i got.

    1. (1) The adjustment is temporary. Share price movements in the short term are a function of supply and demand, so there is every chance the value will move back up to Rs 1000 (or beyond) since the dip was not for any fundamental reason.
      (2) Selling 2% of your shares would permanently reduce your holdings by 2%, incurring brokerage & security transaction tax in the process (and short term capital gains, if you bought the shares less than a year ago)
      (3) Assuming the company share price increases next year due to better earnings, you would benefit from a higher dividend payout if the company maintains its dividend payout ratio (since you own more shares having bought some with your dividends) as well as gains from capital appreciation as the market values the shares higher.

  3. Thanks for the reply. One more query then. Assuming I am going to be reinvesting the dividend,how is this any different from say a share split. In a share split too, the adjustment is temporary (short term). Eg, if company announces a 10 to 1 split, the price of each share reduces by 10% same way a 10% bonus would have reduced the price. Since the stock holding remains same in number 1.1 in both split and dividend case, is there any difference?

    1. I wrote an explanation about splits and bonuses here, should help you understand the mechanism – https://cognicrafting.wordpress.com/2015/08/02/capital-adjustment-share-splits-and-bonuses/

      A share split would also reduce the earnings per share in a proportionate manner, since the amount of profit the company makes hasn’t changed, just the number of ways it is divided. Suppose you had 10 shares in a company that had a face value of Rs 10 and earnings per share of Rs 10 and it went for a 10:1 split, you would have 100 shares of face value after the split. The price per share would reduce to 1/10th, as would the earnings per share (You would have 100 shares @ EPS 1 instead of 10 shares @ EPS 10). The percentage of ownership you own in the company is the same in case of a split. If you buy more shares using either fresh capital or dividends, you are increasing your % stake in the business hence you are entitled to a bigger “cut” in the profits.

  4. I have query regarding ex-dividend date so you are trying to say that on ex-dividend date share price will decrease for adjustment is that a good option to buy on that day ??.Also, I have a suggestion can you please add a Pdf and a Print button at the end.

    1. Whether or not you should buy a company’s stock should be a decision based on the quality of the business, competence of management and valuation. If you feel those criteria are met and the price is attractive, by all means go ahead and buy.

      Also, thanks for the suggestion. The site is still a work in progress and some features might be missing for a while. I will definitely try to incorporate a pdf and print button.

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