A dividend is a portion of a company’s annual earnings that it opts to return to its existing shareholders as a reward for them having invested in a firm. It can also act as a “signalling mechanism”, that the firm is profitable and that future prospects for the company are bright.
Generally, the share price of a company will fall by the value of the payment on the ex-dividend date (the last day on which an investor can qualify for the payment by buying the share).
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Types Of Dividend
There are typically three types of Dividends:
The first are the most common and are paid in the normal course of business activity.
Special Dividends, as their name implies, are one-off events and should not be considered to be on-going.
Preferred Dividends are issued to holders of Preferred stock, who are above common shareholders in priority for dividend payments. They can be paid Quarterly, Semi-Annually or Annually but are at the discretion of the Board of Directors and are not mandatory.
Dividends And Trading
The larger the firm and the more profitable the industry, the bigger and more predictable the dividend will be.
Many investors use high paying firms as a building block of their investment portfolios, either to generate income or by re-investing the proceeds back into the share to increase the size of the holding, thereby compounding wealth over time (assuming the share price continues to rise).
This leaves company management in a tricky situation when recessions strike, as a dividend cut can signal trouble ahead for the business.
Often the key to distinguishing between the two is the Dividend Yield and the Dividend Pay-out ratio; if both are too high, the payment may not be sustainable and may be cut.
Alternatively, sometimes fast-growing companies choose not to pay dividends, as they expect a higher long-term return from re-investing retained earnings in future growth opportunities
Some economic theorists argue that a firm’s dividend policy is irrelevant to its share price. While this has not been definitively proved, the growth of share buy-backs, particularly in the US, has changed the focus of investors interest in recent years, such that total return (share price growth plus dividends PLUS share buybacks) is now considered a better indicator of total investment performance.