How to Calculate Share Dividend

Dividends are a critical component of the relationship between a company and its shareholders. They represent a portion of the company’s profits that is distributed to shareholders as a reward for their investment. The practice of paying dividends is an essential part of a company’s financial strategy, and it reflects the company’s willingness to share the wealth generated from its operations. However, not all dividends are the same. Broadly speaking, dividends come in two types: fixed and variable. These two types of dividends are distinguished by the method by which they are calculated and the level of predictability they offer to investors. Fixed dividends are typically associated with preferred stock, while variable dividends are more common among common stockholders, who are entitled to dividends that fluctuate according to the company's performance. Both types of dividends offer different advantages and come with unique risks, which shape the nature of the investment for shareholders.

Preferred stock, often referred to as preference shares, is a special class of stock that carries certain privileges over common stock. One of the key features of preferred stock is that preferred stockholders are entitled to receive a fixed dividend. This fixed rate is predetermined at the time the shares are issued and is typically expressed as a percentage of the par value of the preferred shares. Unlike common stockholders, whose dividends are variable and dependent on the company’s earnings, preferred stockholders are guaranteed a fixed dividend payout, as long as the company does not face financial distress or bankruptcy. The fixed dividend provides a predictable income stream for investors, which can be particularly attractive for those seeking stability and a steady return on investment.

The fixed dividend rate for preferred stock is generally established based on the perceived risk of the investment, the company’s financial situation, and prevailing interest rates in the market. In most cases, the fixed dividend is paid on a quarterly, semi-annual, or annual basis, depending on the company’s policies. The benefit of this fixed dividend is that it offers a certain level of income security for preferred stockholders, who can count on receiving a consistent return as long as the company remains solvent. This makes preferred stock particularly appealing to income-focused investors, such as retirees, who rely on dividend payments to supplement their regular income.

However, despite the advantages of a fixed dividend, preferred stockholders face a significant risk if the company encounters financial difficulty. If a company experiences a downturn in its business or faces a liquidity crisis, the fixed dividend payments to preferred stockholders take priority over the dividends paid to common stockholders. This means that, in a worst-case scenario, if a company has insufficient profits to cover all of its dividend obligations, preferred stockholders must be paid first. This structure offers a level of protection, but it is important to note that preferred dividends are not guaranteed in all circumstances. In cases where a company faces severe financial trouble, it may suspend or reduce its dividend payments, including those to preferred stockholders.

Common stockholders, on the other hand, are entitled to variable dividends, which are not fixed or guaranteed. The amount of the dividend paid to common stockholders depends entirely on the company’s financial performance, as well as its decisions regarding the allocation of profits. Common stockholders are essentially the residual claimants of a company’s earnings. This means that they are entitled to dividends only after the company has paid all of its other obligations, including fixed dividends to preferred stockholders and any other financial commitments, such as debt repayments. The variable nature of common stock dividends means that they can fluctuate from year to year, or even from quarter to quarter, depending on how well the company performs.

The amount of the dividend paid to common stockholders is determined by the company’s board of directors, who decide how much of the company’s profits will be distributed as dividends and how much will be retained for reinvestment in the business. If the company is performing well and generating significant profits, the board may choose to declare a large dividend, rewarding shareholders for their investment. Conversely, if the company faces a downturn in performance or if the board decides to reinvest profits into the business for growth or to reduce debt, the dividend payout to common stockholders may be reduced or even eliminated. This inherent variability means that common stockholders face more uncertainty in terms of the income they can expect to receive from their investments.

The variable nature of common stock dividends also means that shareholders may benefit from potential increases in dividends during times of high profitability. If a company consistently generates strong earnings, common stockholders may enjoy progressively higher dividend payouts, which can enhance the overall return on their investment. In some cases, companies may implement a progressive dividend policy, where dividends increase gradually over time as the company grows and becomes more profitable. This type of policy is particularly attractive to investors who are focused on long-term wealth accumulation and are willing to accept the risks of fluctuating dividend payments for the potential of higher returns in the future.

While common stockholders have the potential for greater rewards, they also face greater risks. Since their dividends depend on the company’s performance, there is always the possibility that a company may choose not to pay a dividend at all, especially during times of financial difficulty. If the company experiences losses or a downturn in the market, the board may decide to suspend dividend payments in order to conserve cash, reduce debt, or reinvest in the business. This uncertainty in dividend payouts can be a disadvantage for shareholders who rely on consistent income from dividends. Moreover, in cases of bankruptcy or liquidation, common stockholders are the last in line to receive any payments, meaning they may not receive anything if the company’s assets are insufficient to cover its obligations.

The decision to pay a fixed or variable dividend depends on several factors, including the company’s financial stability, growth prospects, and capital needs. Companies that are in the growth stage or that operate in volatile industries often prefer to reinvest their earnings to fuel expansion or to manage risks, which may result in lower or no dividends being paid to common stockholders. On the other hand, mature companies with stable cash flow and less need for reinvestment may be more likely to pay regular dividends, which can attract investors seeking income and stability.

For investors, the choice between preferred and common stock can be influenced by their investment goals, risk tolerance, and income needs. Those seeking predictable income and lower risk may prefer preferred stock because of the fixed dividends, even though this often comes at the cost of higher potential returns. Preferred stockholders benefit from a steady income stream, and their dividends are paid before common stock dividends, making them less vulnerable to market volatility. However, they may not benefit as much from a company’s growth or the appreciation of its stock price. Common stock, on the other hand, is suitable for investors who are willing to accept a higher level of risk in exchange for the potential of higher dividends and capital gains. While common stockholders face more uncertainty, they also stand to benefit more from a company’s success, particularly if the company raises dividends or experiences significant stock price appreciation over time.

In conclusion, dividends are an essential component of the financial strategy for both companies and investors. While fixed dividends offer preferred stockholders a guaranteed and predictable income, variable dividends provide common stockholders with the potential for higher returns based on the performance of the company. Both types of dividends have their advantages and disadvantages, and investors must carefully consider their own financial objectives and risk tolerance when deciding which type of stock to purchase. Companies, in turn, must weigh the benefits of rewarding shareholders with dividends against the need to reinvest profits to sustain long-term growth. The choice between fixed and variable dividends is ultimately a reflection of the company’s strategy and the broader economic environment in which it operates. Understanding the differences between these two types of dividends is critical for investors who wish to make informed decisions and maximize the value of their investments.

Examples:

(1) A stock trader bought 5,000 $1 8% Preference Shares at $3 each and 10,000 $1 Ordinary Shares at $4 each. At the end of the year, the directors of the company declared a dividend of 30% on the ordinary shares. Calculate the total dividends.
Solution:
Preference share dividends = 8% * 5,000 * $1 = $400
Ordinary share dividends = 30% * 10,000 * $1 = $3,000
Therefore, the total dividends = 400 + 3,000 = $3,400
(Note that we should use nominal value, not market price, as part of the calculation)

(2) An investor owned 55,000 7.5 percent preferred stocks which were issued at a par value of $0.50 per share, then:
Total Preferred Dividends = 55,000 shares * $0.50 * 7.5% = $2,062.50