From Joshua Kennon,
Your Guide to Investing for Beginners.
FREE Newsletter. Sign Up Now!

Companies that earn a profit can do one of three things: pay that profit out to shareholders, reinvest it in the business through expansion, debt reduction or share repurchases, or both. When a portion of the profit is paid out to shareholders, the payment is known as a dividend.

During the first part of the twentieth century, dividends were the primary reason investors purchased stock. It was literally said on Wall Street, “the purpose of a company is to pay dividends”. Today, the investor’s view is a bit more refined; it could be stated, instead, as, “the purpose of a company is to increase my wealth.” Indeed, today’s investor looks to dividends and capital gains as a source of increase. Microsoft, for example, did not pay a dividend until it had already become a $350 billion company, long after making the company’s founders and long-term shareholders multi-millionaires or billionaires.

The Process

Dividends must be declared (i.e., approved) by a company’s Board of Directors each time they are paid. There are three important dates to remember regarding dividends.

• Declaration date: The declaration date is the day the Board of Director’s announces their intention to pay a dividend. On this day, the company creates a liability on its books; it now owes the money to the stockholders. On the declaration date, the Board will also announce a date of record and a payment date.

• Date of record: This date is also known as “ex-dividend” date. It is the day upon which the stockholders of record are entitled to the upcoming dividend payment. According to Barron’s, a stock will usually begin trading ex-dividend or ex-rights the fourth business day before the payment date. In other words, only the owners of the shares on or before that date will receive the dividend. If you purchased shares of Coca-Cola after the ex-dividend date, you would not receive its upcoming dividend payment; the investor from whom you purchased your shares would.

• Payment date: This is the date the dividend will actually be given to the shareholders of company.

A vast majority of dividends are paid four times a year on a quarterly basis. This means that when an investor sees that Coca-Cola pays an $0.88 dividend, he will actually receive $0.22 per share four times a year. Some companies, such as McDonald’s, pay dividends on an annual basis.

Types of Dividends

Cash Dividends
Regular cash dividends are those paid out of a company’s profits to the owners of the business (i.e., the shareholders). A company that has preferred stock issued must make the dividend payment on those shares before a single penny can be paid out to the common stockholders. The preferred stock dividend is usually set whereas the common stock dividend is determined at the sole discretion of the Board of Directors (for reasons discussed later, most companies are hesitant to increase or decrease the dividend on their common stock). You can find a detailed discussion of preferred stock and its dividend provisions in The Many Flavors of Preferred Stock: A Possible Investment for Your Fixed Income Portfolio.

Property Dividends
A property dividend is when a company distributes property to shareholders instead of cash or stock. Property dividends can literally take the form of railroad cars, cocoa beans, pencils, gold, silver, salad dressing or any other item with tangible value. Property dividends are recorded at market value on the declaration date.

Special One-Time Dividends
In addition to regular dividends, there are times a company may pay a special one-time dividend. These are rare and can occur for a variety of reasons such as a major litigation win, the sale of a business or liquidation of a investment. They can take the form of cash, stock or property dividends. Due to the temporarily lower rates of taxation on dividends, there has been an increase in special dividends paid in recent years.

To add sugar to spice, there are times when these, special one-time dividends are classified as a “return of capital”. In essence, these payments are not a payout of the company’s profits but instead a return of money shareholders have invested in the business. As a result, return of capital dividends are tax-free.

Special one-time dividends sometimes offer an opportunity for arbitrage.