What are dividends?

March 9, 2016

Dividends are a way to ensure that when companies do well, stakeholders get a fair share of the profit according to how much they have invested. So how exactly do dividends work?

What are dividends?

Dividends are payments a company makes to its investors, based on a set amount of the company’s profit, depending on if they hold common or preferred shares.

At one time, a company’s failure meant personal financial responsibility and could lead to bankruptcy for company directors, officers and shareholders.

  • Once companies were deemed to be legal entities in their own right – or “persons” under the law –that responsibility shifted away from the individual, but payments still had to be made in some way to investors.
  • When a company decided to distribute part of its earnings to shareholders, it did so through dividend payments.

Common vs. preferred dividends

Common shares are the basic stock investors can buy, and they rank below preferred shares, which have “preference” for dividend payments.

  •  A company’s Board of Directors decides what dividend should be paid on common shares, but there is no certainty as to how much you’ll get paid. It can be more, less – or nothing – depending on business conditions.
  • In contrast, preferred shareholders get paid before common shareholders do. They also get paid based on a set formula, so investors know exactly what to expect. That’s why preferred shares are described as “fixed income” investments.

These types of shares also rank higher in the case of bankruptcy, so their holders will get paid first – which means there could be no money left by the time common shareholders come to cash out.

Understanding a company’s dividend policy

There’s more to consider when analyzing a company’s dividend policy than how much you get paid…

  •  Investors often perceive dividend payments as a sign of a company’s strength and proof that they’ll be getting a return on their investment.
  •  Although companies want to make their investors happy, they also have to be careful to keep enough cash on hand to fund their operations.

Too high or too low?

You should be wary of a company that doesn’t seem to want to pay dividends. Why?

  • It’s possible the earnings are being reinvested back into profitable projects instead of being paid out – and that isn’t necessarily a bad thing.
  • Regardless, you should still take a closer look at the company to ensure that’s why you’re not getting paid vs. because its projects are not profitable or corporate expenses are too high.

High dividends, however, aren’t necessarily good either.

  • Most companies need to invest in their growth and projects, and shouldn’t be paying everything out.

The bottom line

While dividends are an important consideration for investors, anyone wishing to buy stock and hold shares in a company needs to research that firm to understand its financial position and dividend policy, to be clear on what that company will pay and why.

Smart Tip provided by The Financial Pipeline. Founded in 1996 by a group of portfolio managers, The Financial Pipeline is dedicated to providing financial knowledge and education to anyone and everyone with even a passing interest in finance. Our motto, “Financial Information For the Rest of Us,” speaks for itself.

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