Investing 101: Dissecting Dividends

Updated: Jul 7, 2020

The word ‘dividend’ is used quite frequently, but few understand what it truly means. Therefore, in this article, I’ll explain exactly what a dividend is, and why investors might want to receive one.

It may sound obvious, but the primary reason behind investing your money in stocks and shares is to make more! This can be done in several ways: through the growth in value of the stocks of companies you have invested in (capital gains), and through the payment of dividends from publicly listed companies to their shareholders. This article will focus on the latter, specifically explaining what dividends are, why companies pay them and how the Covid-19 pandemic has impacted them.

What is a dividend?

The term ‘dividend’ can be seen as an inconspicuous example of financial jargon, but it is actually a very simple term to understand. A dividend is merely a sum of money paid by a publicly listed company such as Vodafone, Tesco, or BP, to its shareholders, usually paid annually or quarterly. The dividend payments will come out of the profits of the company, or their reserves if profits are not sufficient at that time, and the total amount paid out will ultimately be decided by the company’s board of directors. They would typically be paid in cash form, although they can be paid through stock (i.e. a company will give investors more shares), albeit rarely.

As an investor, you would expect dividends to be paid if you hold shares in large, established publicly traded companies. Smaller or growing companies may not offer dividends to shareholders, as they may not have accumulated sufficient profits or funds to be able to pay them out. A start-up company is more focused on investing in research and development to drive growth and expansion, and so, often, they are not profitable in the near-term. However, with large companies equally under no obligation to pay dividends to their shareholders, one has to ask why companies pay them?

Why do companies pay dividends if they don’t have to?

The payment of dividends to shareholders has increased markedly year on year globally since the Financial Crisis of 2008, with 2019 seeing public companies pay out a record $1.37tn in dividends, up 9.3% on the previous year, a notably higher increase than the long-term trend of a 5% - 7% annual increase, according to the Financial Times. There are several reasons why companies might pay dividends to their shareholders:

- Rewarding faithful shareholders. Dividends are often paid to shareholders to reward their faith in the company and its long-term prospects.

- If a company is in a strong position financially. Companies are more likely to pay substantial dividends when they are experiencing a period of strong, sustainable profits, accompanied by strong financial forecasts for the future. Therefore, if a company offers high-value dividends, it is evidence that they are doing well and have significant capital.

- Established history of paying dividends. Many companies have established track records when it comes to paying dividends, which can be seen as a sign of the strength and stability of the company and is attractive to investors. If a company with a long history of paying dividends suddenly decides to cancel or reduce their dividend payments, it may signal to investors that they are in trouble and lead to a fall in stock price. For example, in October 2003, photographic company Kodak reduced its dividends by 43%, which led to an 18% fall in its stock price in a single day.

However, a reduction or cancellation of dividend payments should not necessarily be seen by investors as a negative, as it could mean that the company is looking to reinvest the money into other areas to grow their business.

The impact of Covid-19 on dividends

The unprecedented Covid-19 crisis has manipulated the behaviour of the stock market for the last 6 months and will undoubtedly control proceedings for the foreseeable future. With governments and central banks scrambling to provide economic relief packages to shore up their economy and prevent the further collapse of companies of all sizes, many companies have inevitably adopted cost-cutting strategies to ensure they have enough preserved capital to survive this crisis. This has led to over 300 listed companies in the UK alone cancelling or reducing dividend payments, including Royal Dutch Shell, the UK FTSE 100’s largest company, and the largest payer of dividends. In fact, nine in ten U.K. companies have either cancelled or indefinitely suspended their dividend programme, and in the country, this has meant that over £25bn in dividend pay outs has been cut.

And more dividend pay outs are being cancelled globally with each passing day, particularly with the pressure from governments that have provided extensive loan programs. The U.S. government has even prohibited companies receiving federal financial assistance from paying dividends until those loans are paid back. This pressure is arguably justified as there would be a serious backlash against governments and companies if they were receiving loans while paying shareholders.

In light of a resurgence of coronavirus infections across the pond that has dampened economic forecasts, the U.S. Federal Reserve (or ‘the Fed’) has also capped major bank dividend pay-outs at the reduced levels seen in Q1 of this year, with further limits possible depending on the capital levels of individual banks. This policy aims to ensure the major banks are resilient enough in terms of preserved capital to survive a prolonged economic and market downturn. While some major banks, such as JPMorgan Chase, Bank of America and Citigroup have sufficient capital to continue paying dividends at current levels according to the new Fed requirements, other major players such as Goldman Sachs and Wells Fargo have fallen below the capital requirements, with Wells having to cut their dividend payments as a result. Both banks saw share price drops of nearly 6% last week due to this.

What happens next?

While the economic outlook is gloomy and forecasts offer little assurance, it is expected that dividend payments will return to normal in 2021, with some companies even announcing a return of dividend payments at the end of this year. And the current reduction in dividends hasn’t been all doom and gloom, with share prices turning positively in response to dividend cancellations announced in April, as it is an indication that companies are preserving capital. However, with a spiralling coronavirus resurgence currently sweeping the US, and with the seemingly inevitable prospect of a second wave in Europe before a vaccine is available, it could be disastrous for companies to turn their backs on preserving capital and opting to resume dividend payments with such an uncertain future ahead of them.