The Definition Of A Dividend

The definition of a dividend as it relates to finance is:

a. a pro-rata share in an amount to be distributed

b. a sum of money paid to shareholders of a corporation out of earnings

These seem reasonably straightforward, but as with anything in life, there is much that lurks below the surface...

An investor holding common stock / ordinary shares in a company will receive a return in one of two ways, either through capital gains (or losses) which come from price changes and dividends.

There are practical limitations to a company paying out a dividend. Firstly, the payment must be legal. Company law will lay down the rules and guidelines. A firm must have distributable reserves on the balance sheet to be able to pay a dividend. A company may therefore dip into the undistributed profits of previous years.

Many firms will want to do this to ensure a dividend payment is made every year and maintained at a certain level. Failure to do this can send out a negative signal about the firm. No CEO wants to do this!

A firm also must have the cash available to pay out. Any experienced investor will know that profits do not necessarily mean cash!

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On some occasions, companies will take on extra borrowings to ensure that they can maintain a certain level of annual payment. This type of financial move is more likely from a private equity fund (as owner), but has become more common in recent years.

Again, this would be done to maintain the standing of the company and it's management in the short-term.

Once a dividend is being paid, managements are loathe to miss making payments. Since some collective funds select their investments partly based on dividend policy and history, missing one or more payments can lead to funds selling their holdings.

These sales can lead to an imbalance in the supply and demand of stock available in the market leading to a fall in the price in the market. If one fund were to sell a large holding, this may be problematic, but since many funds use exactly the same criteria for selecting and holding an investment, a cut in size or the failure to pay a dividend can cause a number of fund managers to sell at the same time.

Needless to say, company management does not want to enact a policy that leads to a fall in the price of stock in the market! Such an action might cause their own holdings, or their options, or phantom options, or unvested options to fall in value. Ultimately, it could even lead to the loss of their job, which is why dividends matter.

One of the most famous examples of a dividend payment was the 2005 payment paid by Arcadia group (a UK fashion retailer) to it's owners of GBP1.3 billion. In a show of untypical restraint by a business owner, the following years saw these debts repaid ahead of schedule.

More details about the workings and definition of a dividend can be found on thense pages:

To An Investor, A Dividend Is A Valuable Thing!

Dividend Policy And Dividend Cover

Understanding And Calculating A Dividend Yield

How High Is A High Dividend Yield?

Building A Dividend Portfolio

How Does A Scrip Dividend Work And What Is A Scrip Issue?