Having discussed Market Cap, EPS and PE and pizza in my last post, next on the menu is dividends.
Dividends are a fairly easy concept but people tend to overlook the obvious, namely there ain’t no such thing as a free lunch. No way, no how, no ma’am. But I’m told the best place to start is at the beginning, so…

Divi…yerwhaties?
In the last post, before I started on the pizza, I threw out an analogy of starting a small gardening business with your brother-in-law (or was it a simile … my English teacher was right, I so regret spending his lessons daydreaming about Jenny Braithwaite now). Let’s say that, for the first few years, money in your budding gardening business is a little tight. But after a while things look rosier and it starts to generate a nice profit. Bloomin’ lovely, but what should you do with that profit? Chances are you’ll keep some in the business’ bank account (to pay for new watering cans and the like) and some you’ll take out as pay.

The concept is the same for PLCs. As a shareholder you own a company – or at least a very small part of it. If a company is growing rapidly or in a cash-hungry business it probably won’t pay out any dividends. However once it has grown to a certain size it may decide to keep some of the profits (to pay for future growth and as protection for a rainy day) and hand the rest back to the shareholders as, yep you guessed it, a dividend.

Show Me The Money

Dividends are often paid twice a year in the UK and Ireland and four times a year in the US (although there’s exceptions to every rule).

At the end of every 6 month period (or after 3 months for the US) the company calculates its profits and decides how much money it wants to keep in-house. The rest can then be sent out to the shareholders.

Compare And Contrast (In 300 Words Or Less …)

To make things fair companies generally pay out a certain amount of dividend per share (DPS). So, for example, if a company is paying 3 cents per share and you have 1000 shares your dividend cheque will be €30.

Now you know how we just love ratios in the financial markets … a good set of ratios really makes us feel important (and can compensate for a small willy). Well the main ratio for dividends is called Dividend Yield. Just like we used P/E in the last post to compare different shares according to their cost, so we use Dividend Yield to compare different shares according to their dividend. The formulae is as easy as pie:

Dividend Yield = (Dividend Per Share / Share Price) x 100

The 100 bit at the end, in case you were wondering, just converts the ratio into a percentage.

So, lets say LoadedLikeBeckham plc paid out a total of 60 cents per share over the last year and has a share price today of €12, while PoorerThanOJ plc paid out 10 cents per share over the same period and has a share price of €4. In this example Beckham plc has a Dividend Yield of (0.6 / 12 *100 =) 5% and OJ plc has a dividend yield of (0.1 / 4 * 100 =) 2.5%. So Beckham plc is paying a much higher dividend.

I Would Like A Room For Two With A Balcony And A Bidet

Phrase-book time. It’s always worth knowing a few phrases, even if it’s only so you can prove to the locals that you made some effort! So, the key phrases you’ll need in Dividend-land are:

• Declaration Date: That’s the day on which a company announces how much dividend is going to be paid, and when.
• Cum-Dividend and Ex-Dividend: A share is described as Cum-Dividend if it is trading with the rights to receive the latest announced dividend, and is described as Ex-Dividend if it is trading without the rights to receive the latest dividend. And if that is as clear as mud, the next point should make things clearer.
• Ex-Dividend Date: If a share pays a dividend twice a year then there has to be a cut-off date after which, if you buy the share, you aren’t entitled to the dividend. That date is called the ‘Ex-Dividend date’. In other words if you own a share and want to receive the latest dividend don’t sell it until on or after the Ex-Dividend date. Or, if you are looking to buy a share and you want to get the latest dividend, make sure you buy it before this date. Oh, and if you really want to sound like a pro make sure you abbreviate these terms to ‘Ex-Div’ and ‘Ex-Div Date’. That’s what we say on the street. Man.
• Pay Date: The date on which your dividend cheque for the investor’s shares are handed to Postman Pat to deliver (or, more likely in this wired world, the funds are electronically transferred to your bank account). However in spread betting the dividend payments are made before the Ex-Div Date rather than on the pay date (see below), so I just left this one in here for completeness really.

Right, that’s the basics covered. There’s plenty more to say about dividends but if you want chapter and verse, including answers to questions such as

– when should a company start paying dividends?

– how much of its profits a company pay out as dividends?

– why do some companies let you take your dividend either as cash or as shares

then check out this 5-page article on About.com.

Are Dividends A Good Idea?

“Absolutely” cry the majority of small shareholders. “We own the company and if the company is generating a profit then we should be entitled to some of that.” However these small shareholders are forgetting the most basic, the most obvious rule of the financial markets: there is no such thing as a free lunch.

The money that pays for the dividends isn’t free – it comes straight from the company’s bank account. So if a company is paying out €30 million in dividends, the day it makes the payment it’s bank account is going to be €30 million lighter. Which means the company is worth €30 million less. And so the share price will fall.

How much will the share price fall? If the company has paid out 30 cents per share then you can do the maths it’ll confirm what your common sense is telling you anyway: the share price will fall by 30 cents. So by paying a dividend a company is giving with one hand but taking away with the other. In theory it’s a zero sum game.

Looking at this issue from a different angle, we can say a company that pays a dividend is distributing some of its wealth, so it’s share price will grow more slowly than an equivalent company that isn’t paying a dividend.

Only Two Certainties In Life

From an investor’s perspective there’s one major factor we haven’t taken into account yet. As bright-as-a-button spread betters you guys are relatively untouched by taxes. However the same is not true for people who invest in shares.

As a share investor, when a share price goes up the main tax to pay is Capital Gains Tax. And amongst taxes CGT is relatively kind – it’s around the 20% mark in the UK and Ireland but helpfully you can offset any losses from your dogs against the profits from your star performers.

Dividends, on the other hand, are subject to big bad Income Tax. No offsetting here and, depending on your country and your status, you may be paying 40% or more. So investors in the higher income tax band might well be better off investing in shares that don’t pay a dividend but whose share price will grow at a faster rate.

Of course the majority of shares are owned by funds rather than individuals, and some of these are ‘offshore’. In some cases an offshore fund will not pay any tax on dividends at all at all at all, and so are very keen indeed on dividend-paying stocks.

How Dividends Get Handled In Spread Betting
Right, we’ll split this part into two. First we’ll do the effect of the dividend payments, then the effect of the drop in share price.

Let’s say you have a long position with a rolling daily bet, which is roughly equivalent to owning the share. In this case you get paid 80% of the gross (before tax) dividend. However, as a spread bet is a bet on the share price movement and no-one actually owns the share, the interesting question is “who is paying the dividend?” And the answer is …. those people who have a short position. So if you have a short position on a rolling daily bet (equivalent to having lent out the share to someone, even though you don’t own it) you have to pay 100% of the gross dividend.

Why is it the shorts have to pay 100% but the longs only get 80%? The 20% difference goes towards the admin costs of the whole system – and contributes a little towards paddypowertrader’s profits. Which is something you might want to bear in mind (although in many cases the numbers involved are pretty small).

Oh, and if you want to check your dividend payments click on the Account Management tab at the bottom of your Trading window. Dividend payments should be clearly listed.

Now let’s have a quick look at the change in share price due to the dividend. We said before that on the day the company goes ‘ex-div’ the share price drops. So let’s say Vodafone goes ex-div on the 3rd March and the dividend is 3 pence per share. If the share price closes on the 3rd March, 4.30pm, at £1.80, and if there is no major news overnight to affect the share price, then in theory it should open on the 4th at £1.77. In reality there is almost always some news so spotting the dividend effect can be hard. However lets keep things simple for now.

Now if you have a long rolling daily bet on Vodafone you’ll find the bet closed at £1.80 and was opened again the next morning at £1.77. Again you have lost 3 pence (although it would be easy not to notice it). And again if you had a short position rather than a long one you would have gained 3 pence.

Quarterly bets are act quite differently to rolling daily bets. I won’t get into it here (this blog is already longer than some Shakespearean plays) but the way the maths are worked out means that dividend payments are taken into account. So if you hold a long position on the Vodafone March bet on the 4th March you’ll see neither a dividend adjustment on your account nor any dividend-related change in the bet’s price.

Before we go any further we need to take a few steps back. For most stocks the impact of the dividend is small – and the smaller the dividend yield the smaller the impact. What can be more important for traders are the wider impact that dividends have on share price and the message they send. Read on and be illuminated.

Grab That Umbrella… Just In Case
If a company hits troubled times a decent dividend can help to protect a company’s share price from falling too far. The Dividend Yield formula, if you remember (and if you don’t you really ought to think about asking Santa for one of them Nintendo brain game thingies ‘cos we didn’t cover it that long ago) is:

Dividend Yield = (Dividend Per Share / Share Price) x 100

So, assuming the dividend per share stays the same but the share price falls then the Dividend Yield goes up.

Once the Dividend Yield hits a certain level – often around 4% to 5% – the share will start to attract the attentions of those investors (including the offshore funds we mentioned) that particularly like dividends. So be a bit careful when shorting stocks that have a Dividend Yield reaching or exceeding the 5% mark; they might not fall as fast as you’d like.

It Never Rains But It Pours
Of course company execs know full well that a dividend can protect their share price (and hence their bonuses) when times get rough. Hence they hate reducing the dividend and will only do so when they have to (i.e. when the company is no longer making enough profit to be able to comfortably pay out all that money). And the city fund managers know the company execs hate cutting dividends. So if they see a company cutting a dividend they know something is badly wrong - and will sell the stock. And of course the company execs know the city investors will dump the stock if the dividend is cut so they’ll do their damnedest to not cut it. And so on. The long and the short of it is that if a company cuts it’s dividend then no matter what it says it’s in trouble.

And To Conclude
Wow, we’ve covered a lot of stuff in this post. So here’s a quick summary:

• Some companies pay dividends, others don’t. The ones that don’t are often fast-growing or in a cash-hungry business.
• The Ex-Dividend date is the date before which an investor needs to buy a stock in order to receive the latest dividend.
• The share price will drop slightly on the ex-dividend date.
• Dividends are, in theory, a zero-sum game as companies that pay a dividend are reducing the growth rate of their share price. In practice an investor’s attitude to dividend will be determined by their tax situation.
• If you have a long rolling daily bet on a share paying a dividend you’ll receive 80% of the dividend. If you have a short rolling daily bet on that share you’ll pay 100% of the dividend. What’s more, the bet price on the ex-div day will reflect the change in the share price due to dividends.
• Quarterly bets don’t have any dividend payments and their price is unaffected by dividends.
• Companies don’t cut dividends unless they really have to – cutting a dividend is a sign of distress.
• As a spread bettor you don’t receive dividends. However the (small) change in the share price will have an impact on price so it have a (usually slight) negative impact if you have a long position or positive impact if you have a short position.

And that’s your lot for now. The last of this set of three megalithic posts will be in stock indices so look out for that.

‘til then I hope the markets are with you.

EDITORIAL NOTE: This post was edited on the 17th December at 16:58 to include further information about how spread betting companies handle dividends.