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. A special dividend is a dividend that is paid one time and is usually more than the regular dividend.
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.
Are there any drawbacks to a special dividend?
At first glance, a special dividend might seem like an absolute good since 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 expand the business. For fast-growing technology companies, there should be ways to invest excess cash in the business whether through acquisitions or new capital investments.
Another drawback of special dividends is taxes for the investor. Dividends are the only form of income that is double-taxed by the IRS. The business pays taxes on its net income each year, and then you are required to pay taxes on the dividends once they reach your account. Tax rates can reach 20% for qualified dividends and could be even higher for unqualified dividends. Even if you choose to immediately reinvest the dividends, you'll owe taxes at the end of the year.
It is often better for the business to buy back stock than issue a special dividend. If it buys back stock, your ownership stake in the company goes up and the stock price should go up as well. You can then choose how and when to sell shares to raise cash if you want. That way, you control your tax rate.
How does a special dividend impact share price?
As stated above, the share price falls by the amount of the dividend on the day the dividend is paid. This is because the value of the cash is no longer included in the intrinsic value of the business. If the business is strong, the price will return to previous levels in time.
Over the long term, steadily growing stalwart-type businesses with a reputation of paying special dividends will trade for a premium over businesses that don't. This is because income investors hungry for cash will figure out there are special dividends to gain and bid up the price of the stock by buying shares.
For fast-growing companies, there may be a short-term drop because investors are worried about future growth opportunities. If management is effective at communicating what the capital plan is and why the dividend is being issued, the stock should do fine over the long term.
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Conclusion
If you already own a stock that announces it will be paying a special dividend, that's great news! However, it may not be worth it to try to focus your investments on special dividend payers. The stock price will likely trade at a premium, and there are probably better ways for the company to use the cash or return it to shareholders.
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