Publicly owned companies declare a cash dividend based on net earnings or net income. Ordinarily the firm will issue an announcement several weeks prior to the actual distribution of earnings. Once the board of directors determines the amount of the forthcoming cash dividend, a public declaration of the record date is announced. Shareholders who own the stock on the set record date are eligible to receive a dividend. Dividends are paid from net income.
Understanding Net Income
A firm that pays a dividend to shareholders of both preferred and common stock deducts the amount paid as preferred dividends from revenue along with taxes, interest expense on bonds and other outstanding debts during the process of figuring net income. The resulting bottom line, the net income of a company is what remains to be split among shareholders of common stock -- technically, the owners of the company.
The announcement of intention to payout a cash dividend does not alter net income in that the declaration alone does not affect net income. However, dividends are paid on shares of common stock by dividing the net income between shareholders and the results are spoken of as "earnings per share."
Earnings Per Share
Earnings per share (EPS) equal net income divided by number of outstanding shares. Should the board of directors, under the direction of management, declare a dividend and pay most of the net income to shareholders, investors call the firm's shares a "high-yield" stock. Contrastingly, should the firm retain the majority of net income and reinvest the capital back into the company, its shares are considered "low-yield" stock. Many growth stocks are low- or zero-yield. Investors still buy shares of growth stocks intending to profit from capital gains, selling the shares in the future for a higher price, along with the expectation of possible future dividend payouts.
Because common stockholders own publicly traded companies and are paid last, the greatest financial risk falls to them. Realistically, public companies issues millions of shares of common stock, along with millions of dollars in corporate bonds, but for the sake of simplicity suppose the fictitious firm, the XYZ Gizmo Company issues 1000 shares of stock at $10 per share. The board of directors declares a dividend of $0.25 to be paid November 1 to shareholders of record September 15. This means that after they pay expenses, taxes, institutional creditors, bondholders and preferred stockholders, the XYZ Gizmo Company has a net income of $250, if they retain no earnings, to be divided pro rata among shareholders of common stock.
- "Investment Analysis and Portfolio Management"; Fifth Edition; Frank K. Reilly and Keith C. Brown; 1997
- Principles of Accounting: Chapter 15 Financial Reporting and Concepts
- University of Massachusetts Lowell: Dividends
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