BUYING FOR DIVIDENDS
Whilst a capital gain is an obvious reward sought by investors, many investors do buy shares for the income derived from the dividends that companies pay.
There are several terms that you will hear when it comes to dividends, and it is important that you understand the terminology. Once a company has declared an upcoming dividend, its shares will trade ‘cum dividend’ for a while. This means that the shares are trading with the dividend and if you buy the shares, you are entitled to the dividend.
‘Ex dividend’ means the shares are trading without the dividend and if you buy the shares, you are not entitled to the dividend. Any seller of the shares on or after the ex dividend date is entitled to the dividend (assuming they were holding shares before the ex dividend date).
The price of the shares will drop on the ex dividend date, approximately by the amount of the dividend, to reflect the loss in value from the dividend payout.
For example, if a company is trading at 50c, and is cum a 4c dividend, with an ex date of 10 June, it is obvious why, after the ex date, the shares are trading without the dividend. If you buy on 9 June at 50c, then on 10 June, the shares will be trading at around 46c, so all buyers (on or after the ex date) go without the dividend and all sellers at 46c get the 4c dividend (if they bought cum dividend).
The logic behind the drop in price is fairly obvious, but it should be explained, because many first-time investors believe that dividends offer a potential get-rich-quick scheme. Going with the above example, if you bought shares on 9 June at 50c and the shares were going ex the next day, you wouldn’t be able to sell at 50c the next day and get the 4c dividend. Otherwise, investors could go in, buy shares the day before their ex date, receive the dividend and sell at their original price the next day. You could become a millionaire in no time at all by trading ex dividend dates.
Obviously, shares drop to reflect the loss of value from the pay-out. However, it is important to note that whilst this drop almost always happens, shares have been known to retain some or all of their value on the ex date.
Another term that you may hear is the ‘record date’ (or book closing date). This date is a few business days after the ex date, and accounts for the fact that it takes a few days to settle a trade.
Investors often wonder, if the ex date is 10 June, and they buy on 9 June, will they get the dividend? Yes, they will: the record date is the date that accounts for the three-day settlement, which is the time it takes for you to ‘officially’ own the shares. Therefore, the record date is the point of reference for ascertaining eligibility for the dividend.
Despite many shareholders being confounded by it, and mistaking it for the ex date, the record date is of no real significance to shareholders. The record date is only relevant to brokers, providing them with a timeframe within which to complete all paperwork pertaining to the dividend. They must notify the share registry as to who owned what shares at which date. Shareholders should simply focus on owning the shares on the ex date if they want the dividend.
The ‘payment date’ is typically three or so weeks after the record date and as the name suggests, this is the date on which shareholders get paid their dividend.
Dividend Reinvestment Plan (DRP)
Many companies offer a Dividend Reinvestment Plan, which enables shareholders to elect to receive all or part of their dividends in company shares rather than cash. Shares issued this way are usually issued at a discount to the share price, and the transaction costs are paid by the company.
The main advantage of a DRP to a shareholder is that it is an inexpensive and easy way to accumulate/increase a share position.
For the company, it is effectively a sale of new shares and the conservation of cash, as opposed to paying the dividend out in cash. Many people wonder whether they should participate in dividend reinvestment plans or not. The answer to this is simple; if you want to own more shares in the company, it is a good buy of acquiring those shares, and if you don’t want to own more shares in the company, then clearly it is not worth participating.