The Fool FAQ

Dividends

The Fool FAQ

What are dividends and why do some companies have them while others don't?

Dividends are a redistribution of a company's earnings directly to its shareholders. The most common form of a dividend is a cash dividend.

Imagine that you, fellow Fool, are the founder and CEO of Grits 'R Us (NYSE:GRU), a $50-billion company that sells southern food around the nation and the globe. Off those $50 billion in sales for 1996, the company turned a tidy 6 percent of pure profit, or $3 billion in cash. Let's further assume that there are 1 billion shares of GRU being traded on the New York Stock Exchange. This means that for every share of stock, there are $3 of earnings. Agreed? $3 billion in profits, 1 billion shares, $3 of profit per share.

Naturally, what your investors want is growth. They want Grits 'R us to conquer the culinary world. If this year you turned $3 billion in profit, next year you'll be expected to turn somewhere in the ballpark of $3.45 billion, a 15 percent jump year over year. Searching the planet for and locating another $450 in pure profit -- that's no small task. And if your company does find it, the Street will come back hungering again, looking for $4 billion of earnings from Grits in the succeeding year.

Not surprisingly, what many monstrous companies come to realize is that they just can't meet Wall Street's growth expectations; they can't, for instance, achieve pure growth compounded annually at 15 percent or higher. At some point, they've exhausted their market. In the case of your company, you'll max out on grit sales sooner or later; your target customers probably aren't going to put the gruel down more than twice a day for you. The question then arises: Should you look for other businesses to diversify into? Conventional thinking dictates that the best way to locate new growth is to enter new industries. Should Grits 'R Us Inc. diversify into the world of computer Software (GritSoft), and telecommunications (Voice-Mail 'R Us) and precious metals mining (Golden Grits)?

For many companies, and hopefully for your chophouse, the answer is no. Diversification at the industry level is costly, requires levels of shrewdness and discipline that few possess, and can serve in the long run to undermine the effectiveness of your core business.

Think then what a difficult position the largest companies in the world find themselves. They're shrewd enough not to take too many risks trying to court totally new markets. But if they don't meet Wall Street's growth expectations, their stocks fall out of favor, their brand names get stung, and they don't have the same outlet for raising capital that they once did.

So what are companies to do if they can neither meet Wall Street's growth expectations nor find moderate-risk, alternative businesses? They pay cash dividends to shareholders. Compensating shareholders by paying out earnings directly to them is a way to moderate growth expectations. Shareholders who get the equivalent of a steady 3 to 5 percent each year off their investment just from four quarterly dividend payments don't cash out as readily when the company falls short of double-digit growth. The quarterly payments also attract older investors who , into retirement, need to generate regular income from their savings. Quarterly cash payouts from companies meet those needs. In many ways, the dividend acts as a safety net.

I keep hearing about the Record Date and Payout Date and something called Ex-dividend. When do I have to buy a stock in order to receive the dividend?

Business text books will tell you that there are three important dates for dividends: The Declaration Date, the Date of Record, and the Payment Date. But my text book, at least, didn't mention the only one that is really important to investors--the ex-dividend date. Here's how the whole process works:

Declaration date: This is the date on which a company's Board of Directors actually sets the amount of the next quarterly dividend. Typically it is many weeks in advance of the actual payout date. The amount is set and announced to the shareholders. The declaration is usually worded something like this:

On June 2, 1998 the company will pay a dividend of X cents to sharesholders of record as of May 15.

Record Date: In the above example May 15 is the Record Date. That's the day that a person has to actually own shares in the company in order to receive the declared dividend. Essentially a big list of shareholders is drawn up on that date and checks are sent to those owners. Now, you will immediately be wondering "what about people who trade on that day?" Good question. Keep reading.

Ex-dividend date: In today's electronic reality, the record date isn't what it used to be. (Imagine rows of clerks compiling lists of shareholders by hand.) Transactions occur so fast that we are actually down to a Record Instant.

The stock exchanges have stepped in to make the process work efficiently by declaring an ex-dividend date. On that date, actually at the instant the market opens, the stock is declared ex-dividend, "ex" meaning "without|" dividend. Two things happen. First an x goes next to the stock symbol to let anyone buying it know that they won't be receiving the dividend. Second, all pending orders to buy or sell are reduced by the amount of the dividend unless the buyer or seller has specifed other wise (by using a Do Not Reduce order). The price is reduced because the value of the company has just been directly reduced by the amount of the dividend.

The x-dividend date is usually 3 days in advance of the record date to give all orders time to settle by the record date.

Now, you are wondering about stock held in street name, right? These days the lists of Shareholders of Record read like the Manhattan Yellow pages under Stock Brokers. No problem. The brokers handle all of the book-keeping. If your trade was executed before the stock "went x-dividend," the brokers will pass the dividend along to you when they get it.

Payable Date: Checks go out.

What is "dividend capture"? This is a term I heard from an investing infomercial. It sounded like a really safe and easy way to make money in the market. Is it really that good?

Dividend capture is the idea that you can buy a stock just before the dividend is paid, hold it just long enough to collect the dividend, then sell it. If you can sell it for as much as you paid for it, you have "captured" the dividend at no cost to yourself. Lovely idea, eh? But is it Foolish?

This is one of those ideas -- and not a new one by any means -- that is easier said than done. It might work with some of the lower dividend stocks, and if you have a whole bunch of money sitting around, it might even be a way to make money with little risk. But not a lot of money and not without some risk -- and a lot of work. There are easier alternatives.

The first problem is finding a stock that pays a high enough dividend, like around 8%. They are out there, but they aren't that common. The 8% is paid out quarterly, so the most you can get from any one capture is 2%, which is why you need the high dividend yield in the first place. Of course, 2% isn't bad for a short time period. But you still have to find the stock first -- and that isn't easy -- at least, it isn't easy to find before everyone else has bought into it in anticipation of the dividend, driving the price up (and your return down).

Next, you have to be able to sell the stock within a short time for at least as much as you paid for it. This is the real tricky part. The problem is that the price of a stock is reduced by the amount of the dividend paid. A few weeks before the dividend checks go out is something called "ex-dividend" day. When the exchange opens that morning, all pending orders for the stock are automatically reduced by the amount of the dividend to be paid. This is because anyone buying after that point won't actually receive the dividend -- and the payment of the dividend reduces the value of the company. (That money comes out of the company's cash balance so the company loses that amount of value when the dividends are paid.)

Now, with a company that is paying 2% annually (0.5% quarterly), that reduction might be lost in the noise level of intra-day trading and you might be able to sell the stock within a few days for the same thing you paid for it. But the higher the dividend, the less likely that becomes, or the longer it takes for the stock to rise back to that level. The time that your money is tied up is absolutely the key to using this strategy successfully.

So, let's best-case it: Say you have $10,000 to use for dividend capture and you find a stock that has declared a nice fat 8% dividend (meaning the quarterly payment will be 2%.) You buy the stock, but unless you buy immediately after the announcement, you will probably find that the price runs up a bit in anticipation of the dividend. Why? You aren't the only one who has noticed this bargain! After the ex-dividend date passes and you are assured of receiving the dividend check ($200), you place an order to sell the stock at the price you paid for it. Depending on the company and the market, that price may or may not come along for a few days or months. When it comes along, you sell the stock.

If you buy right after the dividend is announced, you will have to hold the stock for at least a month to six weeks, even if the price bounces back immediately after the ex-dividend date. If you wait to buy until just before the ex-dividend date, you risk buying at a price that anticipates the dividend, which means that when the price is reduced, it isn't as likely to come back up quickly. All of this depends on the company and the market, of course. But don't ever bet that Mr. Market is unaware of this -- when you go looking for a free lunch, it is safer to assume that Mr. Market has been there first -- and eaten all the best stuff.

You can usually find low brokerage commissions, around $8 a trade, but that is usually only for market orders and you will need to place limit orders to make this work out, which will probably cost you a minimum of around $13 per trade. So your net is $174. Now, if you can do this once a month for a year and have it work out in your favor most of the time, you can make $2,088 on your $10,000. That's 21% -- less than you would have made in an index fund during any of the last three years.

But what about during bad markets -- 21% would be great during most years, wouldn't it? Sure, it would. Reality is such a bummer, though. That 21% is possible only when the market is really roaring along. In a slow market, your money will be tied up longer and longer waiting for the price to build back up. So it works best in a hot market, but in a hot market, your returns aren't as good as an index fund. If you can't beat that no-work approach, why go to all this trouble?

You might be able to turn your money around faster by buying lower dividend stock. Some of the bigger companies pay out 2% dividends (0.5% quarterly) where the price reduction on ex-dividend day does indeed get lost in the noise. With your $10,000 you could capture $50 at a cost of $26 in commission (net $24) and only have your money tied up for maybe a week. Do that 52 times a year and... oops, that's only $1,248. Never mind. ; )

Obviously, to do this successfully, you need a pretty big cash stake. With enough cash, commissions can be virtually eliminated. But then you run into problems of actually placing a huge order without driving up the price -- and selling out without driving down the price. Darn. It's always something.

If you need another nail in this coffin, there is the fact that you pay ordinary tax income tax rates on dividend income, but if you were in an index fund, most of your gains will qualify for lower capital gains tax rates.

This is a good example of what is wrong with many heavily promoted Easy Money investing strategies. They sound good, but in reality they are simplistic and shallow. They work only in certain special circumstances that aren't that common, but unless you know a lot about them (and many successful investors don't know much about these obscure techniques because they aren't worth the time it takes to learn them well), it's easy to be fooled into thinking that they are a great deal. With 20-20 hindsight, it's easy to find examples that look good -- but much harder to create them consistently.