What is Dividend, its types, and how to calculate it

A dividend is a payment made by a company to its shareholders from the profits it generates. A company usually distributes the money after setting aside capital to meet its expenses and growth aspirations. Dividend payments are often made quarterly but could be half-yearly or yearly too. 

Now let’s elaborate on what dividend yield is. The dividend yield is basically the dividend per share as a percentage of the share price of a corporation. For example, when a stock trading at Rs 50 gives out a Rs 2 dividend per share, the dividend yield is 4 per cent. 

As of the record date, all shareholders of a dividend-paying company are eligible for dividend payment. The board of directors of a firm determines its dividend, which then needs to be approved by shareholders.

Early-stage businesses with strong growth rates rarely pay dividends. This is because they prefer reinvesting their profits towards continued expansion and high growth rates. On the other hand, established businesses prefer to reward their investors with consistent dividend payments.

Types of Dividends in Share Market

Having understood what dividend is, let’s learn about the types of dividends in the share market. The most typical types of dividends are listed below:

Interim Dividend

The interim dividend is often paid before the annual audited financial statements. Since the current earnings are unknown, interim dividends are paid from retained earnings from previous fiscal years. There could be multiple interim dividend payouts throughout the year. 

Cash Dividend

The most popular form of dividend payout is through cash. The payment is made through currency notes, cheques, or electronic transfers, the latter being the most preferred mode. 

Scrip Dividend

Any corporation that is short on cash may decide to distribute dividends in the form of promissory notes that will be paid to shareholders at a later date. 

Dividend payout ratio

It is the ratio of the amount distributed by a company as dividends and the company's net income. It essentially indicates the percentage of earnings paid to shareholders as dividends.

Dividend payout ratio = Total Dividends Paid / Net Income

It can also be determined by dividing the dividend per share by the company’s earnings per share (EPS).

Dividend payout ratio = Dividend Per Share / EPS 

Alternatively, Dividend Payout Ratio = 1 - Retention Ratio (where retention ratio is the ratio of capital retained by the company and its net income). 

Companies that do not pay dividends have a payout ratio of 0%. While those that distribute 100% of their net income in the form of dividends have a payout ratio of 100%. A young, expansion-focused business would reinvest its earnings in growth, creating new products, and entering new markets. Typically, such companies would have a low or even nil pay-out ratio. 

How to evaluate dividends

The dividend payout ratio is one of the several tools to evaluate a stock’s dividends. Now that you’ve understood what dividend pay-out ratio is, let’s understand other methods of dividend evaluation. 

Net Debt to EBITDA Ratio – Net debt is the company’s total liabilities less its cash and cash equivalents. EBITDA is the earnings before interest, tax, depreciation and amortisation. The ratio of net debt to EBITDA indicates how much debt burden a company has on its books relative to its earnings. A high net debt to EBITDA ratio could indicate that the company could reduce its dividend payout in the future to service the debt.  

Dividend Coverage Ratio – It is the inverse of the dividend payout ratio. 

Dividend Coverage Ratio = 1 / Dividend Pay-out Ratio = Net income / Total dividends paid

The Dividend Coverage Ratio signals how much reserve capital a company has after distributing dividends and whether it has sufficient reserves to invest in growth or to tide over an unforeseen crisis.

Conclusion

Dividend payments made by the company directly impact share prices. A stock’s price may increase upon announcement of a dividend by an amount roughly equal to the dividend declared, and then it may again decrease by the same amount during the opening session following the ex-dividend date. The ex-dividend date is a day before the record date and is the last date for investors to buy a stock to receive a dividend payout. 

For instance, a stock that is trading at Rs 60 per share announces a Rs 2 dividend. The share price could rise by Rs 2 and reach Rs 62 as the news spreads. If one business day before the ex-dividend date, the stock is trading at Rs 63 per share, after the ex-dividend date, the market price may adjust by Rs 2, and the stock would start trading at Rs 61 at the start of the next trading session.

FAQ

Q. How often do shareholders receive dividends?

Dividends are usually paid to shareholders on a quarterly basis. Some companies may pay them half-yearly or annually. 

Q. What is a dividend example?

The dividend is $5 if a company's board of directors votes to pay a 5% yearly dividend per share, and the shares are worth $100. Each payment would cost $1.25 if the dividends were distributed every quarter.

Q. Why do dividends matter?

Dividends can give investors recurrent income. Many stocks are popular among investors for their generous dividend pay-outs and are informally called ‘dividend stocks. It also shows that a company has a steady cash flow and is making consistent profits.