What is a Dividend: Benefits and Types

A dividend is a share in a company’s profit that is paid to stakeholders. There are several types of dividends that differ based on the purpose and payment method.

Let us discuss what is a dividend, its different types of dividends and what are its benefits in this article.

Table of Contents

• What is a dividend?
• Which Entities Pay Dividends?
• Benefits
• Types
• How do dividends work?

What is a Dividend?

Dividend is the distribution of corporate earnings of the company to its eligible shareholders. The amount of dividend to be paid is determined by the board of directors of a company.

A dividend refers to the payment made by the company while sharing profits with the shareholders. When companies start making profits, they share the dividend with shareholders.

To understand how dividends are paid out, let us consider an example. Suppose that you have 40 shares of an organization. The organization pays $3 as annual cash dividends. Then, you will be able to receive $120 annually. A company earns profits to which the board of directors approve a plan for sharing profits as dividend.

Dividends are paid per share of the stock on a monthly, quarterly or semi-annual basis. There is an announcement by the company about the payment. In this announcement, the amount and ex-dividend date is also informed about. Then, the company pays out dividends to its shareholders.

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Which Entities Pay Dividends?

The following entities pay dividends:

• Shareholders of dividend-paying stocks own shares in companies and distribute part of their profits as dividends.
• When mutual funds hold dividend-paying stocks, the dividends are typically passed on to the fund's investors.
• Many ETFs distribute dividends received from their underlying holdings to ETF investors.
• Preferred stockholders have priority in receiving dividends before common stockholders.
• REIT investors are required to distribute a large portion of the taxable income to their shareholders as dividends.
• Bond investors pay regular distributions similar to dividends.
• Owners of dividend-paying Master Limited Partnerships (MLPs), frequently pay distributions to their unit holders.
• Members of cooperatives distribute profits to their members in the form of dividends or patronage dividends.
• Some of the mutual insurance companies also pay dividends to their policyholders.

Benefits

The following are the benefits of distributing dividends to stakeholders:

• As companies start paying dividends on a regular basis, it helps them in gaining respect among investors.
• Any stock that pays a dividend is capable of providing a stable and growing income stream.
• Investors highly value those stocks that can maintain paying a dividend even in difficult times.
• On average, the stocks that increase their dividends at the maximum level outperform the broad market.

Types of Dividend

The following are the different types of dividends:

1. Cash Dividend

It refers to a payment made by the company to shareholders in the form of cash. When a company generates profit, it may distribute a portion of profit to shareholders as a cash dividend. These are paid on a per share basis, which means that every shareholder will receive a set amount of cash for every share of the stock that they own. Through cash dividends, the company rewards its stakeholders as an ROI for their investment in the company. Such types of dividends indicate the stable and profitable health of the organization since they are able to share the profits with stakeholders.

2. Stock dividends

These are the types of dividends that companies issue to their stakeholders. Instead of distributing cash, a stock dividend is paid as additional shares to the company’s stock. Basically, companies divide their existing shares into smaller pieces. By issuing this, the company protects itself from depleting the cash reserve. It also helps the company in increasing the liquidity of the company’s stock and making it more accessible to its investors.

3. Scrip Dividend

It is paid out as either promissory notes or IOUs that may be redeemed for stock or cash at a later date. Basically, the company creates a debt obligation to its shareholders as company promises to pay shareholders with certain amount of money/stock at a later date. This is done in the exchange for acceptance of a scrip.

When companies want to preserve their cash reserves, they use script dividends to reward shareholders. However, shareholders may have to pay taxes on the value of scrip even if they have not received the cash payout. This type of dividend comes with the risk that the company may not be able to fulfil the obligation of paying dividend in the future.

4. Liquidating dividend

This is paid to shareholders when company liquidates its assets. It is paid from the company’s earnings or from the proceeds of sales of company’s assets. This helps in returning a part of the remaining value of the company to shareholders. It is paid on a per-share basis due to which every shareholder receives a certain amount of cash for every share of stock that they own. Th is paid out after every debt and obligation of company are fulfilled. This includes secured debt, other liabilities and taxes.

How Do Dividends Work?

Dividends work in the following manner:

• Declaration: The company's board of directors declares a dividend at a board meeting. This declaration includes the dividend amount per share.
• Payment Process
• • Announcement: The company announces the dividend, including the size, ex-dividend date, record date, and payment date.
  • Ex-Dividend Date: If you purchase a stock on or after this date, you will not receive the next dividend payment.
  • Record Date: Shareholders who are on the company's books on this date will receive the dividend.
  • Payment Date: The date on which the dividend will be paid out to shareholders.
• Impact on Share Prices: On the ex-dividend date, the stock price typically drops by about the amount of the dividend, reflecting the payout.
  Reinvestment
• Dividend Reinvestment Plans (DRIPs): Some companies offer options where shareholders can automatically reinvest the cash dividends to purchase additional shares in the company.
• Taxation: Dividends are often taxable income for the recipients. The tax rate can vary based on the type of dividend and the shareholder's tax situation.