The distribution of the earnings of a company that it has generated over the year amongst its shareholders is known as dividends.
Dividends are determined and decided by the directors of the company, and it can be in any form. It depends on the preference of the director that whether they wish to distribute the earnings in the form of cash payments, property or the shares of stocks.
Just like the capital gains tax has rates that are decided by the IRS similarly the dividend also has a dividend rate.
The rate can be mentioned in the form of dollars and the amount of share each shareholder would receive, or it can be mentioned regarding percentage that reflects the current market price. It is also known as the dividend yield.
It depends on the company that whether they wish to distribute the earnings amongst the shareholders or whether they wish to retain their earnings.
However, another option that the companies have is to repurchase their shares in the open market, which is known as the buyback strategy.
Moreover, the dividend payments can be either paid to the shareholders altogether, or the dividend payment can be divided in a way that it ensures an ongoing flow of dividends to the people.
Dividend Discount Model
The dividend discount model is a model that is used to determine how much money stock will pay in the future.
The dividend discount model uses the analysis of net present value to make predictions. Hence the dividends are then further discounted to their current value.
The discounted amount of the current value will highlight the idea that whether a particular stock is overvalued or it is undervalued.
An undervalued stock is the one in which the current value of the future dividend is more than the value of the stock that exists in the market then.
However, the stock is considered to be overvalued if the present value is more. To determine the current value of the future dividends, the dividends per share are divided by the discount rate that is subtracted from the growth rate of the dividend.
Here is the formula that can be used to generate the present value of future dividends:
Present Value of Future Dividends – Dividends Per Share/(Discount Rate – Dividend growth rate).
Which Companies can issue the Dividends?
Not all businesses can issue dividends to its shareholders. High growth companies offer bonuses rarely mainly because the profits that they generate over time are used and reinvested to make sure that they can further expand or make their business grow.
Enterprises that are already fully established experience regular dividends as they not only seek to maximize their profits and expansion rates but they also tend to optimize the wealth of their shareholders. Such companies include oil, gas, banks, healthcare, pharmaceuticals, etc.
However, there are many criticisms and arguments over the issuing of dividends. One of the main arguments is that of the bird in hand argument.
According to the bird in hand argument, the investors are less sure about receiving any capital gains from the retained earnings than they are about receiving capital gains from current dividend payments.
Furthermore, the way company plans out to issue its dividend may vary from company to company but the primary process and the methods that are used are almost the same.