The primary purpose of any business is to create profit for its owners, and the dividend is the most important way the business fulfills this mission. When a company earns a profit, some of this money is typically reinvested in the business and called retained earnings, and some of it can be paid to its shareholders as a dividend. Paying dividends reduces the amount of cash available to the business, but the distribution of profit to the owners is, after all, the purpose of the business.
Some companies pay "stock dividends" rather than cash dividends, in which case shareholders receive additional stock shares.
The amount of the dividend is determined every year at the company's annual general meeting, and declared as either a cash amount or a percentage of the company's profit; see The dividend decision. The dividend is the same for all shares of a given class (that is, preferred shares or common stock shares). Once declared, a dividend becomes a liability of the firm.
When a share is sold shortly before the dividend is to be paid, the seller rather than the buyer is entitled to the dividend. At the point at which the buyer is not entitled to the dividend if the share is sold, the share is said to go ex-dividend. This is usually two business days before the dividend is to be paid, depending on the rules of the stock exchange. When a share goes ex-dividend, its price will generally fall by the amount of the dividend.
The dividend is calculated mainly on the basis of the company's unappropriated profit and its business prospects for the coming year. It is then proposed by the Executive Board and the Supervisory Board to the annual general meeting. At most companies, however, the amount of the dividend remains constant. This helps to reassure investors, especially during phases when earnings are low, and sends the message that the company is optimistic with respect to its future performance.
Some companies have dividend-reinvestment plans. These plans allow shareholders to use dividends to systematically buy small amounts of stock often at no commission. Dividends are not yet paid in gold certificates although this idea has been discussed by mining companies such as Goldcorp.
Companies have often avoided paying dividends for several reasons:
- Company management and the board believe that it is important for the company to take advantage of opportunities before it, and reinvest its recent profits in order to grow, which will ultimately benefit investors more than a dividend payout at present. This reasoning is sometimes right, but is often wrong, and opponents of this reasoning (such as Benjamin Graham and David Dodd, who complained about the practice in the classic 1934 reference Security Analysis) usually note that this comprises company management dictating to the business's owners how to invest their own money (i.e. the profit of the business).
- When dividends are paid, shareholders in many countries, including the United States, suffer from double taxation of those dividends: the company pays income tax to the government when it earns any income, and then when the dividend is paid, the individual shareholder pays income tax to the government on the dividend payment. This is often used as justification for retaining earnings, or for performing a stock buyback, in which the company buys back stock, thereby increasing the value of the stock left outstanding. The shareholder pays no income tax on this transaction.
In the United States, credit unions generally use the term "dividends" to refer to interest payments they make to depositors. These are not dividends in the normal sense and are not taxed as such; they are just interest payments. Credit unions call them dividends because, technically, credit unions are owned by their members, and the interest payments are therefore payments to owners.