Dividends are distributions of cash, stock, or property made to a corporation’s shareholders.
When a company generates an operating surplus, the company must determine how to best use that surplus. A public company has five alternatives for its cash surplus. The company can (1) invest in future growth, (2) acquire other businesses, (3) pay down debt, (4) repurchase outstanding shares, or (5) pay dividends. Of course, private corporations have these alternatives with the exception of share repurchases.
Dividends are one of two ways in which a (public) company returns excess cash to shareholders. The other method of returning cash to shareholders is share repurchases. When a company repurchases shares, it increases the proportional ownership of existing shareholders.
Although the term “dividends” is often used interchangeably with the terms “owner distributions” and “owner draws”, this is not accurate. Dividends refer to distributions made from a C-Corporation, while owner distributions and owner draws are distributions made from an S-Corporation (or sometimes some other form of business organization).
The distinction in the above terms is important, as dividends represent a form of double-taxation. In other words, C-Corporations pay taxes on the corporation’s earnings, and shareholders also pay taxes on dividends received.
Although dividends are generally paid in cash, firms can also distribute stock or property directly to shareholders.
Investors who are concerned with receiving dividends should pay attention to the firm’s operating cash flows, as a firm will be unable to sustainably pay dividends if its operating cash flows are insufficient.
Dividends may be paid to a firm’s common shareholders or preferred shareholders. Dividends paid to preferred shareholders have priority over dividends paid to common shareholders.
