Understanding the different types of dividends available, how dividends work and what to expect can help you make more informed investment decisions within your overall portfolio.
Before delving into the different types of dividends available, let’s start by understanding what dividends are.
Derived from the Latin word dividendum, or thing to be divided, dividends are a specific percentage of a company's profits that are paid to shareholders at regular intervals. When you invest in a company (by buying shares), you become a part owner of said company, which then entitles you to a percentage of their profits. The ratio of dividends paid out to company’s profits (net income) is called the Dividend Payout Ratio (DPR). Typically, a DPR resting between 30% to 50% is considered good (some argue that dividend payout ratios over 50% are unsustainable in the long run).
The main reason that companies offer dividends is to incentivize investors. They act both as a direct and regular reward to the investor but also signal general financial health, which creates trust in the firm.
Before we investigate the types of dividends – understanding key dates is imperative, to understand strategies:
Declaration date: The day the board announces its intention to pay dividends, and usually includes all other dates in the announcement.
Ex-dividend date: The date before which investors must buy shares in a company to be eligible for upcoming dividends.
Record date: The date that the company uses to determine which shareholders are entitled to a dividend.
Payment date: The day on which the company pays out its dividends.
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The 5 most popular types of dividends are:
- Cash dividends
- Stock dividends
- Scrip dividends
- Liquidating dividends
- Property dividends
Below is a small outline of each:
These are the most popular types of dividends. Cash dividends are paid out in cash to the investors, usually on quarterly basis.
Stock dividends can be paid out instead of cash. Investors receive their equivalent value in additional stock, which aren’t taxed until the shares are sold. However, some say that this method can weaken the value of the shares. For example, if a company issues a 10% stock dividend, it increases the number of shares by 10%. If you owned 100 shares, you now own 110.
A common misconception is that stock dividends increase the value of a company. They don’t. Rather, they further divide the business into smaller parts, consequently diluting the value of the stock.
Some shareholders prefer stock dividends over cash because they create options. Investors have the flexibility of either holding their shares or selling some or all of them, effectively creating their own cash dividend.
The IOUs of dividends. Scrip dividends are issued in the form of certificates rather than stock or cash. These certificates offer shareholders the choice of receiving cash or stock dividends later. If a business doesn’t have enough cash to pay out its dividends, it can issue out scrip dividends, which can come with additional interest for the investor as well.
Whilst the issuance of scrip dividends could indicate poor cash flow health, it can also be seen in a positive light if the company wanted to use the cash for capital investment.
As its name suggests, these are dividends issued when a firm is being liquidated. This can happen after a liquidator distributes all the companies’ assets to pay creditors, e.g., utility bills, rents, financing agreements, wages and future tax liabilities, and there is surplus cash to distribute to the shareholders.
Some companies opt to give assets or inventory to shareholders instead of cash or additional stocks. Property dividends can come in the form of shares of a subsidiary company or physical assets owned by a company such as real estate or inventory. While this is not common, when it is done, companies calculate the value of assets based on the current market value of said assets.
A dividend yield is the ratio of the amount a company pays in dividends to its shareholders relative to its share price.
This is calculated by:
Dividend / price of 1 share
For example, if you invest in a company that has a share price of $10, and the dividend distributed is equivalent to 50 cents, the yield is: 50/1000*100 = 5%. Yields between 2% and 6% are generally considered to be good, but there are many other factors to consider as well.
Key points to consider when looking at dividend yields
When considering dividend investing, you should start by putting in place your objectives around which your strategy will be placed.
A few examples of objectives could be:
Each of these objectives will affect the characteristics of the companies you are considering and how their dividends are paid out. For example, if generating additional income is your primary objective, make sure you aren’t investing in a firm that pays out in stock dividends.
Similarly, if you are mitigating your risk, don’t invest in smaller firms that have very high yields, as these could come with high risk as well. Also, as we have seen the correlation between stock price and dividend yield, this could mean that the stock’s price is falling due to the risk of the dividend being cut. Instead, considering an ETF of dividend stocks may be a safer option, as it lessens the risk of one stock dropping in value and cutting back its payments.
As with all investing, receiving dividends is not a guarantee as these are based on performance.
Another niche trading strategy which is popular with day and swing traders is the Dividend Capture Strategy. It involves an investor buying shares of a stock just before its ex-dividend date and selling as soon as the dividend payment is paid. The idea is to capture the dividend without needing to be a long term holder of the stock.
The pros of this strategy are that it is adaptable to most market conditions, it’s easy to screen and find dividend paying stocks on an almost daily basis and it can generate income in a short period of time. However, the stock price may decline after a dividend is paid which can reduce profits, there may be transaction fees and you may not be able to capture the full dividend if the stock price increases significantly before the ex-dividend date. Note, you should also take into consideration your personal tax thresholds when assessing net income from this strategy.
Dividend-based investment strategies are a legitimate way of increasing your passive income. However, with so many different options, it is important to investigate the mechanics and details of how you would be receiving your payments, how often, in what form etc.
Dividend yields are a great way to gauge the ratio of income to your investments but beware of very high yields as these could mean unsustainable payouts or a dropping stock price.
Lastly, investing in any stock always comes with a risk so please do your own research or take appropriate advice accordingly.
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