Dividends & CFDs
What is a dividend?
A dividend occurs when a company’s board decides to distribute a certain amount of earnings amongst shareholders. Dividends can be in cash, stock or other property, however cash is most common. The size of the dividend payment received by a shareholder is proportional to the amount of stock they own. For example, if you own 1,000 shares of Mad Horse Inc and the board decides on a dividend of 50c per share, you’ll receive a dividend cash payment of $500 into your bank account.
Why do companies pay dividends?
Companies pay dividends to distribute earnings to shareholders. Using cash dividends as an example, there are two broad reasons for paying a divident:
- If the company has few growth opportunities and little need for the funds, shareholders are better off with the funds. From an investment perspective, the shareholders could achieve a higher return investing the funds elsewhere
- Investor psychology: It can be rewarding for investors to receive regular dividends in exchange for their investment (and risk tasken) to support the company. It can also be reassuring for a shareholder to take full possession of their share of earnings, rather than leave it in the company where the individual shareholder has less (or no) control over how it might be utilized.
What kinds of companies pay dividends?
Not all companies pay dividends. Dividends are more common with larger, more mature companies with positive net earnings and limited growth opportunities. Growth companies usually do not pay dividends.
To understand this better, let’s explore some scenarios:
A growth company that doesn’t pay dividends:
Imagine a small company valued at $1m. It has 3 employees, a useful but basic product, and big dreams (i.e. strong growth prospects). They need all the cash they can get to hire new staff members, rent new offices or store fronts, to improve their product, expand their distribution and to generate sales (with sales teams, advertisements etc). If successful, the returns can be big. If they grow from a $1m to a $10m company over a few years, their return on every dollar invested is (10/1 - 1) x 100 = 900%, which is vastly superior to the market average. It is very common for growth companies not to pay dividends.
A growth company that pays dividends:
Imagine the same $1m company from the previous example. They still have a team of 3 and a useful but basic product. Even at this small scale, maybe they see sufficient sales to generate positive net earnings (covering all their costs + profit). If the company pays some or all of the profit to the shareholders, the company has foregone funds that could have been used in its growth. For a company with strong growth prospects, a dividend is a poor decision as the shareholders either need to re-invest their dividend (which is now less than what they were paid out thanks to tax), or raise the funds by some other means.
A mature company that doesn’t pay dividends:
Mature companies with well established operations don’t have to pay dividends, at least not consistently. It’s up to the board to declare a dividend and the amount of the dividend. Some reasons a mature company might not pay a dividend include:
- Negative net earnings year (i.e. negative profit)
- Using earnings to pay off debt
- Saving earnings for new growth initiatives (big companies can grow too), or a restructure
- Saving earnings for a “rainy day”, for example, if the economic outlook is uncertain
A mature company that pays dividends::
Mature companies with consistently positive earnings can pay dividends to shareholders, as shareholders will likely realize a better return on these funds than the company would. The amount to pay per share is at the discretion of the company, and will usually reflect how strong their earnings period was as well as other ad-hoc factors (for example, upcoming once-off expenses).
How often are dividends paid?
It is up to a company’s board to decide how often to pay a dividend, or whether to declare a dividend at all. It is common for dividends to follow earnings reports, which can be monthly, quarterly or semi-annually.
How does a company decide on the dividend amount?
When a company chooses to pay a cash dividend, the size of the dividend can be influenced by several factors but essentially boils down to strength of earnings, and what they are likely to need cash for in the near term. More excess cash and fewer planned expenses can generally mean a larger dividend. Some factors influencing the size of the dividend may include:
- How strong a company’s recent earnings period was
- A company’s upcoming growth initiatives
- A company’s upcoming once-off payments (such as legal fees)
- A company’s upcoming restructuring plans
- Paying off debt
- Economic uncertainty (saving for a rainy day)
What’s the ex-dividend date?
The ex-dividend date is the date on which a new shareholder will no longer be entitled to a recently reported dividend that is yet to be paid.
How do dividends affect the stock price?
Upon announcing but before the ex-dividend date, a company's stock price should not be affected. Merely announcing a dividend does not create nor remove value from the company.
On the ex-dividend date, new shareholders are not entitled to the dividend. They therefore expect the shareprice to be discounted by the dividend amount.
Another way of viewing this is that the share price declines by the dividend amount because dividend funds (assume cash assets) are no longer in the company’s possession. They are owed to the shareholders, who will be paid out soon.
From a shareholder’s perspective, value has neither been created or destroyed. The stock price has reduced, but they now have the appropriate amount of cash from the dividend to offset that reduction.
On September 22nd, NASDAQ’s Apollo Tactical Income Fund Inc. (AIF) had their ex-dividend date for a declared dividend of 9 cents per share.
The chart shows the share price dropped by approximately 9 cents that day. In this case the share price decrease was likely largely due to the dividend, however in many cases share price fluctuations due to other factors can mask the effect of the dividend. We see the share price recovers within days due to other factors.
Do Stock CFDs pay dividends?
CFDs (Contracts for Difference) make adjustments to your holdings to account for dividends. If you take a long position on a stock before its ex-dividend date, your account will be adjusted positively to reflect the dividend payment. If you take a short position on a stock before its ex-dividend date, your account will be adjusted negatively to reflect the dividend.
Discover new assets with CFDs
CFDs (Contracts for Difference) offer a way to gain exposure to a wide range of assets, including local and international shares, commodities, cryptocurrency and more. With CFDs, you can ride price movements of an asset without physically holding the asset.
If you're looking to trade international shares, CFDs can give you exposure to price movements without the administrative hassle and cost of registering as a foreign stock holder.
Trade free virtual cash on a Plus500 demo account