People having elder siblings may have experienced this several times in their childhood. Let’s say there are two sisters, Sita and Gita. Gita is the elder sister of Sita. One day their mother gives Gita some task while leaving for work promising her to pay a nice reward on the completion of the task. Gita also gets a hand from her younger sister Sita. Their mother arrives in the evening from work and gets super happy after seeing the work completed and immediately rewards Gita with delicious chocolates. Gita dances with joy but realizes that even her younger sister had equal rights on those chocolates as she had helped her. Thus, Gita shares her reward with Sita as she also had contributed to the task. Both Sita and Gita enjoy their rewards with great joy.
The concept of dividends can be explained with the above example. Let’s replace Gita with a listed company and Sita with its shareholder/investor who contributes funds to the company for its operations and growth. When the company makes a good amount of profits, it is distributed to its shareholders/investors as they have contributed funds to the company for its business. The chocolates given by Gita to Sita for her help are the same as the profits shared by the company to its shareholders/ investors. Though the concept looks easy, there is much more to learn about it. So, let’s dig in!
A dividend is a part of profits that a company pays out to its shareholders. When a company generates profits, those earnings can be either reinvested fully/partially- as retained earnings in the business, or a fraction of it can be paid out to the shareholders as a dividend. Dividend also refers to a reward for the shareholder for their trust in a company. However, it is not mandatory for a company to pay a dividend (except to preference shareholders). A company’s dividend is decided by its board of directors and it requires the shareholders’ approval. The dividend received by a shareholder is an income for the shareholder and is taxable.
Why do companies pay dividends?
1) Special Dividend- A company often issues a special dividend to distribute profits that have accumulated over several years and for which it has no immediate need.
When any company declares a dividend, they also declare 3 important dates associated with it:
1) Ex-dividend date: The date on which the dividend eligibility expires is called the ex-dividend date or simply the ex-date. For instance, if a stock has an ex-date of Thursday, May 20, then shareholders who buy the stock on or after that date will NOT be eligible to get the dividend as they are buying it on or after the dividend expiry date. Shareholders who own the stock one business day prior to the ex-date—that is on Wednesday, May 19, or earlier will receive the dividend.
2) Record date: On this date, the name of the shareholder should be in the records of the company to be eligible to receive the dividend. The record date is normally set two business days after the ex-date because of the T+2 settlement mechanism followed by the market.
3) Payment date: The company issues the payment of the dividend on the payment date, which is when the money gets credited to investors' accounts.
Well, we know that the stocks of the dividend-paying company should be purchased before the Ex-dividend date as we follow the T+2 settlement cycle to be eligible to receive the dividend. Usually, the last date to buy the share is one business day prior to the Ex-dividend date and hence the impact of dividends on share price is such that on the Ex-dividend date, the share price gets adjusted and is reduced proportionally by the amount of dividend declared with respect to the previous day’s closing price.
e.g.) ABC Ltd. declares a dividend of Rs. 20 per share. If the Ex-dividend date is 10th March and the closing price of the share on 9th March was Rs.100, then on the Ex-dividend date i.e. on 10th March the share price will be adjusted and will trade at Rs.80.
When a company pays dividends, it returns some of its profits directly to shareholders, sending a signal to the market of stable and reliable operations. Newer companies, or those in the technology space, often opt instead to redirect profits back into the company for growth and expansion, so usually, they do not pay dividends. This reinvestment of retained earnings is often reflected in rising share prices and capital gains for investors. So, no company is good or bad based on the decision whether they pay dividends or not, every company has a plan behind their decision. Study the plan and enjoy the investment. Until next time!