Question

A cash distribution of earnings by a corporation to its shareholders is a cash dividend. Although dividends may be paid in other assets, cash dividends are the most common. What are the three conditions for a cash dividend and explain the advantages and disadvantages of cash dividends? Also, describe the three dates included in a dividend announcement and the journal entries involved?

Answer 1

Conditions of cash dividend

A cash dividend is the distribution of funds or money paid to stockholders generally as part of the corporation's current earnings or accumulated profits. Cash dividends are paid directly in money, as opposed to being paid as a stock dividend or other form of value

When it comes to investing for dividends, investors should memorize three key dates: date of declaration, date of record and date of payment. Some companies offer dividend-paying stocks, which give their shareholders a percentage of the profits in cash, usually quarterly

To pay a cash dividend, a company must have earnings or retained earnings because normal cash dividends are a distribution of earnings.

Second, a company must have adequate cash to fund the payment of dividends. There can be circumstances where a company has earnings but no cash (because plant assets were purchased with the cash).

Third, the dividend must have been declared by the board of directors of the corporation. Dividends are not paid regularly like loan payments, but must be decided and declared by the board of directors each quarter. Once declared, they are a legal obligation of the entity.

Advantages Of Cash Dividend

1) A cash dividend means you are receiving a payment in return for your investment.

Effectively this is saying that the whole value of a share is in the dividend they pay. If earnings are not used for dividends now then they are only of value to you as an investor if they are paid at a future date. This future payment should be discounted back to its present value.

Earnings not paid to you now can be reinvested into the company (organic investment), be used for acquisitions, be used for share buybacks, or can pay down debt. If companies do these wisely, then future dividends should be higher.

2) Dividends mean you don't have to sell shares to realize a return.

The stock market is generally fairly good at valuing businesses. This means that if the company you have shares in is consistently increasing earnings per share, then in the long run, the price per share should rise.

That said, valuations can move aggressively and at times stocks can be very undervalued or depressed like in 1974 or 2009.

If you were not receiving dividends and were reliant on your stock portfolio for income at this time then you would have been forced to sell in these down markets, thus selling an undervalued security at a terrible time. We are advocates of never being forced to sell your stocks and regular dividends are a way of helping you avoid being a forced seller.

3) Dividends can support the stock price during a market downturn and reduce volatility.

Several studies into the advantages of dividends have shown that dividend-paying stocks outperform during bear markets and recessions. For example, Nova Southeastern University have pointed out that the dividend aristocrat index outperformed the S&P 500 index by an annualized 29.88% during the 2001 recessionary period and by an annualized 23.71% during the recessionary period of 2008. For the whole 2001-2008 period the dividend aristocrat index outperformed the S&P 500 by 6.45% annually.

A reason why dividend stocks outperform during poor markets is because if the share price is falling and investors feel the dividend is safe, then investors are going to be drawn to buy into the stock because of the yield alone.

4) Dividends can give you a "total return accelerator" during a market downturn (for my money the most powerful of all the advantages of dividends)

As mentioned above, one of the advantages of dividends is that they can protect you during a bear market. They can also help accelerate your returns during a market downturn and help you recover your capital more quickly. This is because you can use your dividend payments to reinvest into cheaper stocks and buy more shares than during higher markets.

5) Dividends act as a "rod" for management and make it more difficult for them to misallocate capital.

Investors in many companies expect dividends not only to be paid but to grow over time. Managers therefore focus heavily on generating the cash to cover these dividend payments. They then need to think about how they invest any retained earnings at the highest rate of return possible so that they grow the dividend in the future.

Disadvantages of Cash Dividend

1) Tax! (Without doubt the most frustrating of the disadvantages of dividends)

There are two distinct disadvantages of dividends from a tax perspective...

The first and most obvious is that, from an investors point of view, it creates a double taxation that wouldn't occur if the earnings were retained.

This is because a company that makes a profit normally has to pay corporation tax. Dividends are then distributed from their after tax earnings. The investor is then also usually liable to pay tax themselves, resulting in this double taxation.

Of course, tax rates can vary depending on the investor's personal situation and investors can avoid or reduce (legally!) dividend taxes by using tax sheltered accounts such as a 401k, traditional IRA (Individual Retirement Account) or Roth IRA.

2) You may not be able to invest the cash as well as the company

If you have invested in a company that earns very high returns on its invested capital then often you, as the investor, would be far better off if they retained that cash to continue earning those high rates of return.

If you are paid a dividend and can't invest that cash as effectively as the company that paid you then you are likely to be worse off in the long run. Often the very best investments are those of companies that consistently earn very high returns on their capital and you want as much of your capital as you can get working for you in that company.

3) The company can't find a use for the cash

One often forgotten disadvantages of dividends is that paying out a large share of earnings to shareholders could signal that the company doesn't have any ideas for its cash.

Whilst a payout here is probably more beneficial than the cash spent in an ill-disciplined way, the fact that the company doesn't know what to do with the cash could send a poor signal about future returns of the business and management's ability to earn good returns in the future.

This could be a long term negative for the company and you should look into this carefully, especially if the stock trades on a high valuation.

4) Management wedded to the dividend could miss some investment/acquisition opportunities

This is somewhat linked to point 2 above. If the management of the company are so determined to keep up payments to shareholders, then it could make it more difficult for the company to pursue excellent opportunities that would benefit shareholders as the funds would have been distributed.

Management of dividend paying companies may also leverage up the balance sheet more aggressively to fund these opportunities, therefore making the company riskier than if that expansion had been funded by the cash that was paid out to shareholders.

5) Not all investors are the same!

This was a point made by Warren Buffett in his 2012 letter to shareholders (on page 19). He argued that investors who needed income could realize the right amount of income from their portfolio by selling the correct amount of shares each year. Dividends don't give that flexibility as they are paid on a per share basis and so some investors are actually receiving more cash than they need!

Three Dates Included in a Dividend Announcement

We all have important dates to remember in our lives such as birthdays and anniversaries. When it comes to investing for dividends, there are three key dates that everyone should memorize. The three dates are the date of declaration, date of record, and date of payment. Most investors buy stocks only for their cash dividends, this is especially true now because interest rates are so low and investors are hungry for yield. However, the next time you decide to buy a stock for its dividend, keep the following three dates in mind to ensure you get the cash you deserve.

Date of Declaration
The date of declaration is when the company’s board of directors announces their intention to pay a cash dividend. Once declared, the company incurs a liability on their books to reflect the proposed dividend to shareholders. At the same meeting, the board of directors also announces the date of record and date of payment.

Date of Record (and ex-dividend date)
The date of record is how the company determines which shareholders are entitled to the dividend. A company maintains a record of all their shareholders, unless the shares are held in street-name. Street-name means you own your shares through a brokerage account. In such cases, the company pays the broker and the broker deposits the cash dividend in your account. The ex-dividend date is two days before the date of record. Investors who own the stock before the ex-dividend date are entitled to the dividend whereas investors who buy the stock on or after the ex-dividend date will not receive the dividend. As a result, the value of the stock declines on the ex-dividend date because the stock trades without the right to the dividend and the value of the company decreases because the dividend no longer belongs to the company

Date of Payment
This is the last date to remember for dividends because the date of payment is when you actually receives the cash dividend.

Sometimes companies pay large special dividends (such as Microsoft in 2004) because they have excess cash on their books and they want to distribute it to shareholders. You could potentially miss out on a cash dividend if you do not pay attention to the three key dates mentioned above. Most importantly, don’t buy a stock just for its dividend. Dividend paying companies are usually mature companies that can no longer reinvest their profits into the business to earn a sufficient return required by their shareholders. You should have a diversified portfolio that includes both dividend and growth oriented companies.