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Subject 2. Background for the Dividend Discount Model PDF Download

A cash dividend is a cash amount, usually paid on a per share basis. It is paid out of retained earnings.

  • Regular dividends are dividends distributed by companies on a regular recurring basis, usually quarterly, semi-annually or annually.

  • An extra dividend is a non-recurring distribution of company assets, usually in the form of cash, to shareholders. Generally, special dividends are declared after exceptionally strong company earnings results as a way to distribute the profits directly to shareholders. Companies in more cyclical industries are also likely to use this form of dividend payment. Extra dividends can also occur when a company wishes to make changes to its financial structure or to spin off a subsidiary company to its shareholders.

There is a belief that there is an optimal price range for every share. This is the price for the share where the price/earnings ratio and hence the company''s value is maximized. Consider a share that has become so costly that investors cannot afford to buy the share in the required even lot of 100 shares. To correct this situation the company would split its stock.

A stock split divides each outstanding share into several shares. In a 2-for-1 stock split, the holder of 1 share will get additional 1 share. It increases the number of shares outstanding and is generally used after a sharp price run-up to produce a large price reduction. Firms generally split their stocks only if the price is quite high and management thinks the future is bright. Therefore, stock splits are often taken as positive signal.

A stock dividend is a dividend paid in additional shares of stock rather than in cash. Stock dividends are expressed in percentage. For example, on a 100% stock dividend, the holder of 1 share will get additional 1 share. Stock dividends used on a regular basis will keep the stock price more or less constrained.

Both stock splits and stock dividends are used to keep stock prices within an "optimal" trading range. They are just more pieces of paper: they both divide the pie into smaller slices without affecting the fundamental position of the current stockholders. As a result, each shareholder will own more shares, but his or her slice of the firm's "pie" remains the same and each share is worth less.

A reverse stock split reduces the number of shares and increases the share price proportionately. For example, if you own 10,000 shares of a company and it declares a one for ten reverse split, you will own a total of 1,000 shares after the split. A reverse stock split has no affect on the value of what shareholders own.

Companies often reverse split their stock when they believe the price of their stock is too low to attract investors to buy their stock. It's usually a bad sign if a company is forced to reverse split. Companies do it to make their stock "look" more valuable, but in reality nothing changes. A company may also do a reverse split to avoid being de-listed.

Under a stock repurchase plan, a firm buys back some of its outstanding stock, thereby decreasing the number of shares, which should increase both EPS and the stock price. Unlike stock dividends and stock splits, share repurchases use corporate cash. It is an alternative way of paying cash dividends.

There are different reasons for share repurchases:

  • Repurchase announcements are viewed as positive signals by investors because the repurchase is often motivated by management's belief that the firm's shares are undervalued. There is no question that the company has more information about itself than does any other entity, and is therefore the ultimate insider.

  • It can remove a large block of stock that is overhanging the market and keeping the price of per share down.

  • If the excess cash is thought to be only temporary, management may prefer to make the distribution in the form of a share repurchase rather than to declare an increased cash dividend which cannot be maintained.

  • Companies can use the residual model to set a target cash distribution level, then divide the distribution into a dividend component and a repurchase component. The company has more flexibility in adjusting the total distribution than it would if the entire distribution were in the form of cash dividends.

  • Tax reason: In some countries tax rate on capital gains is lower than the tax rate on cash dividends.

  • Repurchases can be used to produce large-scale changes in capital structures. For example, if a firm''s capital structure is too heavily weighted with equity, it can sell debt and use the proceeds to buy back stocks, thus increase debt ratio.

A liquidating dividend is a payment by a firm to shareholders from capital rather than from earnings. This isn't really a good thing. It usually occurs when a company dissolves its business or sells part of its business for cash, and distributes the proceeds to its shareholders. The distribution would be treated as a capital gain for tax purposes.

Dividend Payment Chronology

Declaration Date: The date on which a firm's directors issue a statement declaring a dividend. At the time of the declaration, the company will state the holder-of-record date and the payment date.

Ex-dividend Date: The date on which the right to the current dividend no longer accompanies a stock. This is the first date that a share trades without (i.e. "ex") the dividend.

Holder-of-Record Date: If the company lists the stockholder as an owner on this date, then the stockholder receives the dividend. On this day the company closes its stock transfer book. It is typically two business days after the ex-dividend date. Unlike the ex-dividend date, this is determined by the company.

Payment Date: The date on which a firm actually mails dividend checks. The date is determined when the dividend declaration is made.


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