Many investors purposely seek out dividend-paying stocks because they offer the added benefit of a regular income stream. A dividend is a portion of a company's earnings that it pays to its shareholders. Dividends are paid on a regular basis -- typically once per quarter. But occasionally, companies surprise their investors by issuing special dividends.

When a company finds that it has a large amount of excess cash, it might decide to distribute that cash to its shareholders through a special dividend. Unlike a regular dividend, a special dividend is a one-time payment. One well-known example of a special dividend is when Microsoft paid shareholders a total of $32 billion in special dividends in November of 2004.

While special dividends can be a nice bonus for investors, they also have certain drawbacks.

Special Dividends

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Special dividends versus normal dividends

Special dividends should not be confused with normal dividends, which are typically paid quarterly and in uniform installments. While a company can raise its regular dividends, special dividends usually represent a payout that is significantly larger than a company's normal dividend payment.

When a company raises its normal dividend, investors expect to continue receiving higher regular payments on an ongoing basis. This is why companies are careful to announce special dividends -- to keep investors' expectations in check. Special dividends generally don't impact a company's stock valuation or dividend yield because they're one-time events.

Why companies declare special dividends

A company might choose to make a special dividend payment after a period of particularly strong earnings. Generally speaking, dividend payments are a way for companies to share their profits with stockholders. Special dividends are often regarded as a form of sharing a bit of extra wealth. In other situations, a company might announce a special dividend payment at a time when it wants to change its financial structure.

Drawbacks of special dividends

At first glance, a special dividend might seem like an absolute good, as it puts extra cash in investors' pockets. However, sometimes a special dividend can backfire.

First of all, when a company makes a special dividend payment, its stock price is immediately reduced by the amount of that payment. Sometimes, investors will try to sell their shares after receiving a special dividend payment, but if they do, they're essentially wiping out their own profits by taking a hit on the price of their shares. Additionally, the more investors who try to sell following a special dividend payment, the more a company's stock price is likely to drop.

Furthermore, some investors regard special dividends as a sign that the issuing company has run out of opportunities to grow the business. Special dividends can cause a negative reaction among shareholders, which is what happened with Microsoft back in 2004.

While special dividends can be a cause for celebration, they also have the potential to backfire. As an investor, it's important to keep an eye on any company that announces a special dividend payment, as you may be dealing with more than just a little bonus cash.

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