While some stocks do not pay dividends at all, some stock portfolios earn a significant amount of money from dividends. When the stock market is stagnant and the price gains of the stocks in your portfolio yield only an insignificant return, dividend payments can be an important source of profits. While dividends are potentially difficult to predict, you must understand how dividend payments impact your total return.
Dividends are cash payments to shareholders of a corporation and constitute a profit sharing scheme with the individuals and other corporations that own the firm. Dividend payments are at the sole discretion of the firm's board of directors. Even when the firm has plenty of cash, the board may elect not to pay a dividend and invest the money back into the business. Hence, dividends only constitute a financial obligation of the firm once they have been approved by the board. As a shareholder, you cannot be certain of dividend payments beyond the time horizon for which the board has approved such payments, which is almost under a year.
Common vs Preferred Stock
There are two basic types of shares in publicly traded corporations: common stock and preferred stock. Preferred stockholders are entitled to a fixed annual dividend payment. However, the board has the authority to suspend such payments. These shareholders are referred to as preferred because until all outstanding payment obligations to preferred stockholders have been met, the firm cannot legally pay dividends to common stockholders. In case of bankruptcy too, the dissolved firm's assets will be first distributed to preferred shareholders and only then will common stockholders be paid. The downside to preferred stock is that even if the firm is extremely profitable, the preferred stockholders do not receive a greater dividend than the fixed sum to which they are entitled.
Return on Assets
When calculating past return on assets or estimating future potential returns, you must include the actual or predicted dividend payments. Since dividend payments are cash money that are directly deposited into your account, their net effect on your income is no different from any other form of income such as price appreciation on the stocks you hold or interest payments from bonds. Ignoring dividend payments will result in an inaccurate return figure, if you have dividend paying stocks in your portfolio. Naturally predicting future dividends that have not yet been approved by the board of directors involves an educated guess. However, the same type of uncertainty applies to future price appreciation of the stock itself.
Ex Dividend Date
When the board of directors approves dividend payments, the firm will announce the amount to be paid to each type of stock as well as an ex dividend date. The ex dividend date is the first date on which holders of a stock will no longer be entitled to dividend payments. If the ex dividend date on your stock is June 15, you must buy the stock before this date and sell it no earlier than June 15 to receive a dividend. Interestingly, it is sufficient to buy such a stock on June 14 and sell it on June 15 to receive a dividend. There is usually an immediate drop on the stock price on the ex dividend date, however. Therefore a quick stock flip is rarely profitable.
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