What are Dividends

A dividend is a distribution of a company’s earnings to its shareholders and is determined by the company’s board of directors. Imagine you own a piece of a company, and when that company makes money, they share some of it with you. That is a dividend! Dividends are often distributed quarterly and may be paid out as cash or in the form of reinvestment in additional stock.

What are the different types of dividends?

1. Cash dividends:
   This is when companies share their profits with shareholders by giving them money. Let us say a company decides to give Rs. 10 for each share someone owns. If you have 100 shares, you would get Rs. 1,000.
2.  Stock dividends:
   Instead of money, some companies share more of their own stock with existing shareholders. So, if a company decides on a 10% stock dividend and you have 100 shares, you would get 10 extra shares. But, since there are more shares now, the value of each share might go down a bit.
3.  Property dividends:
   Companies do not always give cash or stock; sometimes, they share other stuff they own, like real estate or inventory. It is less common, but some companies choose to divvy up their assets this way.
4. Scrip dividends:
   Instead of cash or stock, some companies give out promissory notes or bonds. These are like promises that can be turned into cash or stock later. It is a bit like getting an IOU for a future reward.
5. Liquidating dividends:
   When a company is closing shop or selling everything, they might give liquidating dividends. This happens after all debts are paid.

Impact of dividends on share prices

Dividends wield a considerable influence on stock prices, acting as a key indicator of a company's financial health and growth potential. When a company declares a dividend, it sends a positive signal to investors, suggesting stability and room for future development. This optimistic outlook can trigger an uptick in demand for the company's stock, consequently driving up its share price.

However, the story changes after the ex-dividend date. At this point, the share price commonly experiences a dip equivalent to the dividend amount. This dip occurs because new shareholders are not entitled to the upcoming payment, prompting an adjustment in the stock price to account for this exclusion.

Companies with a consistent track record of paying dividends often earn a reputation for financial reliability, making their stock more appealing to investors. The perception of stability and reliability can foster increased demand for the stock, leading to a boost in share prices.

Conversely, companies that reduce or eliminate dividends may raise concerns among investors, signalling potential troubles ahead. Such uncertainty can result in a decline in demand for the stock, subsequently driving down its share price.

It is crucial to recognise that while dividends play a significant role, they are just one piece of the puzzle. Various factors, including economic conditions, industry trends, and overall company performance, also contribute to the complex landscape of stock prices. Therefore, savvy investors consider a holistic view, weighing multiple factors to make informed decisions in the dynamic world of stock markets.

Calculation of dividends

The prevalent method for calculating dividends involves the "dividend per share," a measure representing the sum allocated to each shareholder for every share they own. This figure is typically derived by dividing the total earnings available for distribution by the total shares outstanding during a specific period.

Consider the ABC pharma company, which recorded a net profit of Rs 800 crore in the last financial quarter, with 5 lakh shares outstanding. Applying the formula:

Dividend per share = 800 crore/5 lakh = Rs. 1600

In this scenario, each shareholder would receive Rs. 1600 as their dividend per share.

It is noteworthy that depending on the type of dividends issued, additional calculations may be necessary to determine the precise amount each shareholder will receive.

Let us break down other key calculations with examples to shed light on how the dividend-related calculations work.

1. Dividend payout ratio: The dividend payout ratio is like a financial spotlight, revealing how much of a company's earnings find their way into the pockets of shareholders. Imagine a company with a reported net income of Rs. 2,00,000 and pays out Rs. 40,000 in dividends. Applying the formula:
   Dividend payout ratio = 40,000/2,00,000 = 0.2
   The dividend payout ratio in this scenario is 20%, indicating that the company allocates 20% of its earnings to shareholders in the form of dividends.
2. Retention ratio: On the flip side, the retention ratio unveils how much of the earnings a company holds back for future endeavours. Let us say a company declares a dividend of Rs. 8 per share, and the earnings per share stand at Rs. 15. The retention ratio would be:
   Retention ratio= 8/15 = 0.53
   Translated to percentage, the retention ratio is 53%, indicating that the company retains 53% of its earnings for growth and expansion.
3. Dividend yield: For investors eyeing returns, the dividend yield is a crucial metric. Consider a company offering an annual dividend of Rs. 25 per share, with the current market price per share at Rs. 500. Applying the formula:
   Dividend yield = (25/500) × 100 = 5%
   The dividend yield here is 5%, revealing that for every Rs. 500 invested, investors receive a 5% return in the form of dividends.

Armed with these calculations, investors can gain a deeper understanding of a company's dividend distribution strategy. These examples demonstrate the practical application of these metrics, empowering investors to make informed decisions in the ever-evolving landscape of the Indian stock market.

Dividends in the context of financial modelling

A dividend is not categorised as an expense; rather, it is recognised as an allocation of a company's accumulated earnings. As dividend distribution can have a direct impact on a company's overall equity, it plays a crucial role in the realm of financial modelling.

Let us discuss the repercussions of dividends on a company's financial statements.

Balance sheet: When dividends are paid out, they lead to a reduction in both total cash and retained earnings. This is reflected on the balance sheet, where the aggregate cash and the portion of earnings set aside for future use decrease.

Cash flow statement: On the cash flow statement, dividends are documented as a use of cash, specifically appearing under the financing activities section. This categorisation reflects the outflow of cash associated with dividend payments.

Statement of retained earnings: In the statement of retained earnings, dividends are reported as a decrease in the retained earnings. This indicates the portion of earnings that is not reinvested in the company but distributed among shareholders.

Income statement: Contrary to the impact on other financial statements, dividends do not influence the income statement. The income statement remains unaffected as it primarily focuses on the company's revenues, expenses, and net income, excluding dividend-related transactions.

This comprehensive understanding of how dividends affect various financial statements is integral for financial modellers, providing insights into the intricate dynamics of a company's financial position and decision-making.

Meaning of dividend stocks

Dividend stocks emerge as a practical choice for those seeking a balance between reliable income and long-term growth. These stocks, issued by companies committed to sharing their profits with shareholders, hold significance beyond their immediate monetary value. Let us explore what it truly means to invest in dividend stocks through key pointers.

Steady income stream:

• Dividend stocks provide a reliable and predictable source of income.
• Investors receive regular dividend payments, ensuring a consistent return on their investment.

Indicator of stability:

• Companies issuing dividends are often seen as financially stable.
• The ability to share profits indicates confidence in sustained earnings, attracting investors seeking less risk.

Long-term growth potential:

• Dividend reinvestment plans (DRIPs) enable investors to compound their holdings over time.
• Reinvesting dividends contributes to both immediate income and potential long-term capital appreciation.

Diverse investment opportunities:

• Dividend stocks exist across various sectors and industries.
• Investors can build a balanced portfolio by incorporating dividend stocks from different sectors, enhancing stability, and mitigating risk.

Dividend payout ratio vs. dividend yield

In simple terms, dividends are like rewards that companies share with the people who own their stocks. These rewards come from the company's earnings and provide investors with a regular income. This practice also shows that the company is doing well financially. By looking at metrics such as dividend yield and payout ratio, investors can get useful information when trying to figure out the stock market. Whether a company gives lots of dividends for quick income or keeps some money for future growth, knowing about dividends helps investors make smart choices, finding a balance between regular income and the chance for long-term success.