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"Money For Nothing" is not only the title of a song by Dire Straits in the '80s, but also the feeling many investors get when they receive a dividend. All you have to do is buy shares in the right company and you'll receive some of its earnings. How exciting is that? However, despite the advantage, there are several implications involved in the paying and receiving of dividends that the casual investor may not be aware of. This article will explain several of these. But first, let's begin with a short primer.
What Are Dividends?
Dividends are one way in which companies "share the wealth" generated by running the business. They are usually a cash payment, often drawn from earnings, paid to the investors in a company - the shareholders. These are paid on an annual or, more commonly, a quarterly basis. The companies that pay them are usually more stable and established, not "fast growers". Those still in the rapid growth phase of their life cycle tend to retain all the earnings and reinvest them into the business. (For more details, see How Dividends Work For Investors and The Importance of Dividends.) Price Implications
When a dividend is paid, several things can happen. The first of these is what happens to the price of the security and various items tied to it. On the ex-dividend date, the stock price is adjusted downward by the amount of the dividend by the exchange on which the stock trades. For most dividends this is usually not observed amidst the up and down movement of a normal day's trading. However, this becomes easily apparent on the ex-dividend dates for larger dividends, such as the $3 payment made by Microsoft in the fall of 2004, which caused shares to fall from $29.97 to $27.34. (To read more, see Declaration, Ex-Dividend and Record Date Defined and Why don't investors buy stock just before the dividend date and then sell right afterward?)The reason for the adjustment is that the amount paid out in dividends no longer belongs to the company and this is reflected by a reduction in the company's market cap. Instead, it belongs to the individual shareholders. For those purchasing shares after the ex-dividend date, they no longer have a claim to the dividend, so the exchange adjusts the price downward to reflect this fact. Historical prices stored on some public websites, such as Yahoo! Finance, also adjust the past prices of the stock downward by the dividend amount. Another price that is usually adjusted downward is the purchase price for limit orders. Because the downward adjustment of the stock price might trigger the limit order, the exchange also adjusts outstanding limit orders. The investor can prevent this if his or her broker permits a do not reduce (DNR) limit order. Note, however, that not all exchanges make this adjustment. The U.S. exchanges do, but the Toronto Stock Exchange, for example, does not. (For related reading, check out The Basics Of Order Entry.)
On the other hand, stock option prices are usually not adjusted for ordinary cash dividends unless the dividend amount is 10% or more of the underlying value of the stock.Implications for Companies
Dividend payments, whether they are cash or stock, reduce retained earnings by the total amount of the dividend. In the case of a cash dividend, the money is transferred to a liability account called dividends payable. This liability is removed when the company actually makes the payment on the dividend payment date, usually a few weeks after the ex-dividend date. For instance, if the dividend was $0.025 per share and there are 100 million shares outstanding, retained earnings will be reduced by $2.5 million and that money eventually makes its way to the shareholders. (For more insight, see Retained Earnings: What Gets Kept Counts.)In the case of a stock dividend, though, the amount removed from retained earnings is added to the equity account, common stock at par value, and brand new shares are issued to the shareholders. The value of each share's par value does not change. For instance, for a 10% stock dividend where the par value is $0.25 per share and there are 100 million shares outstanding, retained earnings is reduced by $2.5 million, common stock at par value is increased by that amount and the total number of shares outstanding increases to 110 million.
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