Definition and Examples of Distributions
Definition and Example of a Distribution
Distributions are profit dividends on investments. They are paid out of the companies’ profits directly to shareholders, who in turn have the opportunity to reinvest them. Distributions are usually taxable to the shareholder receiving them unless they are in a tax-advantaged account like a Roth IRA.
How Distributions Work
Distributions are an important part of owning stocks. Many investors expect to receive regular payments as compensation for keeping their money in the company. The company’s management will need to determine how much money to retain in retained earnings and how much to return to shareholders.
Note: Retained earnings are important for maintaining capital in the company and reinvesting profits for its future growth.
When a company decides to start paying distributions, it will need to establish the payment schedule and the amount it will pay per share. For example, suppose the company’s board of directors announces that it will pay a quarterly distribution of $0.25 per share. The shareholder who owns 1,000 shares will benefit not only from any increases in the share price but also from quarterly distributions totaling $250. The shareholder can then decide whether to withdraw these distributions or reinvest them in additional shares.
Distribution Date and Payment Date
When a company’s board of directors announces a distribution, it will also announce the distribution date and payment date. The day before the “distribution date” is the day that anyone who owns shares will receive the next distribution, based on the total they own. If you buy the stock the day after the distribution date, you will not receive the upcoming payment, and you will have to wait for any future payments. The payment date is the date when the distribution is actually sent out to shareholders.
Why Many Investors Focus on Distributions
When deciding which common stocks to include in your investment portfolio, focusing on distributions offers several advantages. First, a company’s distribution yield can signal whether a stock is overvalued or undervalued. Academic research over the years has shown that the “quality of earnings” for companies that pay dividends is higher than for those that do not. Over time, companies that pay distributions tend to outperform those that do not.
Good companies have a history of maintaining and increasing their distributions even during periods of economic challenges. Many companies in the consumer staples sector fall into this category. As stable investments, these companies continue to pay distributions.
During periods of economic stress, the distribution can be a factor that limits the decline in the stock price and keeps it from falling as much as non-dividend-paying companies. This is why dividend-paying stocks typically decline less during bear markets. Distributions can also help to rebuild your portfolio by providing income for reinvestment.
As an added bonus, income from distributions is treated favorably for tax purposes. While ordinary distributions are taxed as regular income, qualified distributions are taxed at a lower rate.
Why Some Companies Do Not Pay Distributions
During fast growth periods, many companies do not pay distributions; instead, they choose to retain earnings and use them for expansion. Shareholders allow the board of directors to implement this policy because they believe that the opportunities available to the company will lead to much larger distributions in the future.
Note: Starbucks invested every penny it could into opening new locations for years without paying investors. Once it reached a certain level of maturity and market saturation, with fewer location opportunities in the U.S., it announced its first distribution in 2010.
When
If a company does not pay capital distributions, it is because investors expect to get their money back – either through an increase in the value of the shares or future distributions. This makes the company attractive to investors and may help it raise additional funding in the future.
Types of Distribution Investors
There are several different approaches that distribution investors can take, depending on their investment goals.
Growth Distribution Investors
Growth distribution investors focus on buying stocks that have a high growth rate in cash distribution per share. For example, suppose company A has a current cash distribution yield of 1.4%, and company B has a yield of 3.6%. Since company A is expanding rapidly, investors can expect an increase in the distribution at a rapid rate. It is possible to accumulate more absolute distributions in the long term for a shareholder in company A with a time horizon of a decade or more, even if the initial yield is lower.
Income Distribution Investors
Income distribution investors focus on buying stocks that have the highest distribution yield considered “safe,” which usually means that the stocks are covered by a payout ratio to earnings or cash flows. Portfolio managers will direct this type of management to large companies that pay a distribution that may grow by just a few percentage points a year.
Overall, this strategy is most suitable for an investor who needs significant passive income toward the later decades of life, as dividend growth stocks tend to outperform high-yield stocks.
Dividend Aristocrats
Dividend aristocrats are companies identified by S&P Dow Jones Indices as having increased their cash distribution per share every year, without exception, for 25 years or more. This means that even if you do not buy another share, your distributions have grown with the company. Consider dividend aristocrats as blue-chip companies – the most successful long-term dividend-paying companies.
Reinvestment of Distributions
When reinvesting distributions, you take the money that the company sends you and use it to buy more shares. You can ask your securities broker to do this, or you can enroll in a Dividend Reinvestment Plan (DRIP).
DRIP is a company-sponsored plan that allows individuals and, in some cases, legal entities such as corporations or non-profit organizations to purchase shares directly from the company. DRIPs are managed by a transfer agent and often provide trading and administrative costs at a significantly reduced rate (and in some cases, completely free).
Stock Distributions
Stock distributions differ from regular cash distributions; this occurs when a company gives additional shares to shareholders based on a certain ratio. It is important to know that stock distributions are not a form of income in the traditional sense, but rather often a psychological tool.
Benjamin Graham, the famous value investor and mentor to Warren Buffett, wrote almost a century ago about the benefits of a company that pays a continuous distribution of stock – especially if it retains earnings and does not pay cash distributions – to give shareholders a tangible symbol of retained earnings that have been reinvested on their behalf. Those who wish to generate income can sell them, while those who wish to expand can hold onto them.
Distributions vs. Capital Gains
Distributions and capital gains represent important forms of investor returns, but there are critical distinctions between them.
Distributions are financial returns that come from corporate profits. A capital gain represents an increase in the value of the share. They are not recorded until the shares are sold. Distributions can be scheduled or paid at the board’s discretion. They depend on the market value of the company, not the board’s decision.
They can
Reinvesting distributions or withdrawing them by the shareholder. In contrast, capital gains cannot be realized until the stocks are sold. Profits from capital gains can be reinvested by purchasing more shares or withdrawn by selling the shares.
Key Conclusions
Distributions are a form of investment return paid directly to shareholders from the company’s profits. A company’s board of directors may choose to pay a cash distribution per share on a regular schedule or at any time they choose, or not to pay it at all. Investors can withdraw or reinvest their distributions. Distributions differ from capital gains, as the former represents an increase in the value of the stock, while the latter represents an increase in the value of the stock that is not realized until the shares are sold.
Source: https://www.thebalancemoney.com/what-is-a-dividend-356103
Leave a Reply