What is Extra Dividend
An extra dividend — sometimes called a special or irregular dividend — is a one-time dividend paid to a company’s shareholders of record. Unlike most dividends, which are paid at regular intervals and in pre-determined amounts, extra dividends are typically announced with little-to-no warning; are usually for significantly larger amounts; are nonrecurring; and are paid in cash. Companies think carefully before they announce an extra dividend, not only because of the outlay of cash, but also because doing so may have other ramifications for the company.
What Is A Dividend?
Breaking Down Extra Dividend
An extra dividend is a way for a company to share a windfall of exceptional profits directly with its stockholders. An extra dividend will have the same effect as a regular dividend on a stock’s price, which is that on the ex-dividend date, the stock price will be reduced by the amount of the dividend declared. However, because a stock’s price generally reflects all of the market’s sentiments, the price could be more or less than that amount.
Typically, an Extra Dividend is a Result of Extra Cash
You can think of a special dividend as a one-time “gift” from a company to its shareholders because, for example, the company may have enjoyed strong earnings. But cash can pile up on the balance sheet for other reasons, such as the company spinning-off a subsidiary, a department, or some assets; or, because the firm may have won a lawsuit. Sometimes a company can issue extra dividends if it decides to change its capital structure — that is, the percentage of debt versus the percentage of equity used to finance the company. By decreasing its assets (because dividends are paid out of cash), the firm's debt ratio will increase.
Why Would a Company Pay an Extra Dividend?
A company may use extra dividends strategically — to show shareholders that it is confident in its long-term prospects, for example. By declaring an extra dividend, a company also can signal to the rest of the market that its footing is sound; perhaps to gain more investors, or for other reasons. But whatever the reason, the effect of an extra dividend generally serves to engender shareholders’ loyalty toward the company. So, an extra dividend can be a bonus result of a management strategy, or it can be part of the strategy, itself. Extra dividends also can be useful for companies in cyclical industries. Because these companies are affected significantly by economic changes, their earnings are unpredictable; they might post a profit in some periods and take a loss in other periods. Hence, cyclical companies can use an extra dividend to create a hybrid payout policy. For example, they can follow the normal dividend cycle, but whenever earnings are good in a particular period, they could distribute a portion of them via the extra dividend.
Why It’s Important to Investors
Many investors purposely seek out dividend-paying stocks because they offer the added benefit of a regular income stream. Regardless of whether an investor is interested in generating income, dividends play an important role in the overall performance of any portfolio. And when an investor is looking for stock to hold for the long-term, a company's willingness to pay extra dividends often signals that it is focused on stability, growth, and steady management.
Extra Dividend in Action — Microsoft Corporation
A well-known story about an extra dividend is when, on December 2, 2004, Microsoft paid out a special cash dividend of $3.00 per share (for a total of $32 billion), which was worth 38 times more than its regular $0.08-per-share dividend. On that day, Steve Ballmer — then-Chief Executive Officer of Microsoft — received a dividend check for $1.2 billion; and Bill Gates — then-co-founder and Chairman of Microsoft — also got a big check of nearly $3.4 billion in dividends. These two executives made a fortune overnight because they were investors in their own company.
As an investor in that scenario, imagine buying 1,000 shares in a company and getting paid $0.08 per share every quarter, which is fairly common. After a quarter, you would have $80 and after a year, you would have gained $320, which is fairly decent. Now, imagine that one of those quarterly payments was not $0.08, but instead you received an incredible $3.00 per share. That one payment alone would be worth $3,000; which is like getting nine years of dividend payments from Microsoft in one day! And while Gates and Ballmer received billions on that day in 2004, thousands of everyday investors also got checks — for $1,000, $2,000, possibly even $50,000 or more simply by being invested in Microsoft.
Can we cash in on a similar extra dividend today? That still might be possible with Microsoft, or other companies with massive amounts of cash that pay large extra dividends; but it is very difficult to find the right companies. And, although extra dividends can look very appealing, there are potential downsides, too.
Drawbacks of Extra Dividends
For a Company: Companies might declare an extra dividend thinking that they will have enough cash to fund future projects even after paying the special dividend. But if a company’s judgment is wrong, then the company can risk not being able to take advantage of future opportunities because of having distributed the extra cash. Or, the market could misinterpret a company’s declaring a special dividend to mean that it does not have any new projects to invest in; and this perception could drag down the stock price. Investors looking for growth would not want to be associated with a company that had no reinvestment opportunities.
For an Investor: Extra dividends are not predictable. The temporary growth in a company's cash is not organic; it happens because of some special occurrence. So, for a long-term investor, the extra dividend is really not that important. It has no effect, or a small effect, on valuation; and it is not considered in the dividend yield calculation. Moreover, 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 are essentially wiping out their own profits by taking a hit on the price of their shares. Also, the more investors who try to sell following a special dividend payment, the more a company's stock price likely will drop.
Avoid Temptation to Chase Extra-Dividend Announcements
Although special dividends are not necessarily bad, there is no evidence that they provide any long-term benefit to investors. In effect, they are neutral and sometimes can actually be negative, especially if they result in slower long-term earnings power and dividend growth. Overall, it is never a good idea to chase special dividends. Rather, it is best to stick with high-quality dividend growth stocks that have occasionally paid out an extra dividend. Just remember to always do your research to make sure that you are investing in a company for the long-term, and one that fits your own unique risk tolerance, time horizon, and financial goals.