Dividend Investing

A dividend is a reward distributed by a firm from a portion of earnings, more specifically net profit, to its shareholders. There are different ways for firms to pay dividends, but this article will focus on the cash payment method, since it is by far the most common.

Before dividends can be received by the shareholders of a company, the Board of Directors of that firm decides the amount of the dividend to be paid out per share (or whether to pay out a dividend at all), and the frequency of said dividend payment (e.g. monthly, quarterly or annually).  The date on which this decision is made public is called the declaration date, one of the four critical dates investors should be aware of regarding dividends.

Once the dividend is declared, shareholders or investors looking to receive that dividend have to pay attention to a second date, namely the ex-dividend date (or ex-date). The ex-date is the day on which a certain share begins to trade without the value of its next dividend payment. This means that, for an investor aiming to receive the next dividend payment, the last day on which the share can be bought is the trading day before the ex-dividend date. 

If the shares are purchased on or after the ex-date, the investor will not receive the dividend. This is because of a third critical date, the record date. On this date, the firm makes an inventory of all its shareholders, specifically those eligible to receive a dividend payment. This delay between the date on which the trade happens and the day on which it is settled and recorded in the company’s books (when there is a transfer of ownership), is the reason for the ex-date. It ensures that an investor will receive a dividend if they want to.

For example, for shares listed on the New York Stock Exchange, a T+2 system applies. For a company that has its record date on the Wednesday of a certain week, the ex-dividend date will be set on the Tuesday, meaning the last possible day to purchase the share (if you want to receive the dividend) is on that week’s Monday.

Finally, the date on which the dividend is distributed to the shareholders is the payment date.

Another important notion is the dividend yield vs. dividend amount. The dividend yield, usually expressed yearly, is the amount of the dividend in relation to the price of the share. Let’s take the example of AT&T, a stock renowned for the consistency and yield of its dividends. Currently, a share of AT&T trades at around $38 and distributes dividends on a quarterly basis. The stocks have a payout ratio of 57.24%, a dividend yield of 5.36%, and an annual pay-out of $2.04. This means AT&T pays out $0.51 per quarter per share, which equals to a yield of 1.34%. However, if the stock were to increase in price, AT&T would pay out the same dividend amount ($0.51), causing the yield to decrease for investors purchasing the stock at the higher price.

The payout ratio represents the share of the firm’s profits that it pays out to shareholders. When considering a stock, you should be careful about firms that are very close or over 100%, as they might not be reinvesting enough into R&D or have leveraged themselves in order to make dividend distributions (which will not be sustainable in the long-run).

Now some of you might be thinking that you could simply buy a share with a high dividend yield, collect the dividend, and dump it on the ex-date. Unfortunately, you would not be the first one to have thought of this strategy (often referred to as Dividend Capture Strategy), and the expression “there ain’t no such thing as a free lunch” applies in investing too. The theory behind why this would not work is fairly simple. Imagine you are an investor holding AT&T shares and you know the ex-date is coming up shortly. You now have two choices: you can either keep the stock and collect the dividend, or sell your stock and receive the price for which it is currently traded. However, you would like to receive a premium price for your shares since you know they will sell for more on the stock exchange and that you are about to lose your claim to said dividend. If everyone owning AT&T shares thinks the same way, the price of the share will continuously increase to reflect the upcoming dividend payment, but it will also decrease immediately after the ex-date, to reflect the loss of the dividend. In short, you might not make any profit on such a trade. However, the price of the stock could eventually recover to the price before the ex-date, at which point you could sell, and be proud to have “captured” the full dividend. This might take time though, and the time until recovery will not be the same for every stock, nor will it be the same for every dividend distribution of the same stock.

To illustrate this, we can look at some stocks with high yields that had their ex-dates recently, and see how the share prices reacted: ELNC

Source: seekingalpha.com

ENLC’s ex-date was on the 25th of October, where the share price dropped by around $0.4, which, among other causes, reflects an adjustment to the loss of the upcoming dividend. Moreover, since the dividend to be paid out was only $0.283 per share, an investor would have made a loss of $0.117 per share if they had invested on the day preceding the ex-date. You can also see that the share did not recover immediately and decreased even further.

Moreover, if you are considering holding a stock for a longer period of time, you should also pay attention to the payout ratio of the company. In the case of ENLC, the payout ratio of 486% indicates that the firm is paying out more than it is earning (it could have borrowed to pay out dividends), which is an unsustainable move and should be recognised as a sign that the dividends will not remain this high in the long-run.

Editing by Tom Handels