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 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.

This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors. We'd love to hear your questions, thoughts, and opinions on the Knowledge Center in general or this page in particular. Your input will help us help the world invest, better! Email us at Thanks -- and Fool on!