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What is a special dividend? Examples, pros and cons
If you like being given some extra money unexpectedly, there’s a chance you might like special dividends too.
Here we explore their characteristics, how they compare to traditional dividends, reasons for issuance, the pros and cons, real-world examples, the tax implications and the impact special dividends can have on stock market investment decisions.
Here we explore their characteristics, how they compare to traditional dividends, reasons for issuance, the pros and cons, real-world examples, the tax implications and the impact special dividends can have on stock market investment decisions.
Big ideas
- Special dividends are one-time payments. It’s nice to receive the extra payout as a shareholder but sometimes it is not in the best interest of the company to pay it.
- Existing shareholders should consider the factors influencing the decision to pay the special dividend and any risks to make informed investment decisions.
- If you get a special dividend, consider the tax implications, and explore reinvestment options such as Autoinvest with Trading 212 or DRIPs.
Understanding special dividends
Unlike traditional dividends, which follow a predictable pattern, special dividends occur irregularly and infrequently. The timing of special dividends is not predetermined and can vary based on various factors, such as a company's financial position, excess cash availability, and strategic decisions.
SPECIAL DIVIDENDS DEFINITION
These are one-time payments made by a company to its shareholders, separate from regular dividend distributions.
Special dividends can have a positive impact on share prices. Investors often make the assumption that any company that can afford a special dividend must be financially healthy and succeed in its business.
The announcement of a special dividend can bolster investor confidence and lead to a rise in the share price. But special dividends cannot be solely relied upon for long-term investment strategies because they are not guaranteed or consistent like regular dividends.
The announcement of a special dividend can bolster investor confidence and lead to a rise in the share price. But special dividends cannot be solely relied upon for long-term investment strategies because they are not guaranteed or consistent like regular dividends.
Comparison of special dividends vs traditional dividends
While traditional dividends are distributed regularly, such as quarterly or annually, special dividends do not follow a predictable schedule.
Another key difference is the amount of special dividends, which can vary significantly from company to company and from one distribution to another. Traditional dividends are often determined based on a fixed dividend policy or a percentage of the company's earnings.
In contrast, special dividends can be influenced by the company's financial performance, surplus cash availability, and management's decision to distribute excess funds to shareholders.
Another key difference is the amount of special dividends, which can vary significantly from company to company and from one distribution to another. Traditional dividends are often determined based on a fixed dividend policy or a percentage of the company's earnings.
In contrast, special dividends can be influenced by the company's financial performance, surplus cash availability, and management's decision to distribute excess funds to shareholders.
Characteristics of special dividends vs regular dividends
Characteristic | Special Dividend | Regular Dividend |
Timing | Occurs irregularly and infrequently | Follows a predictable schedule (e.g., quarterly, annually) |
Amount | Varies based on the company's decision and financial position | Typically determined by a fixed dividend policy or a percentage of earnings |
Purpose | Often a one-time payment for distributing excess cash or windfall profits | Regular, ongoing payment to provide consistent income to shareholders |
Market Impact | Can generate positive market sentiment and potentially affect the share price | Generally has a less immediate impact on the share price |
Tax Treatment | Subject to ordinary income tax rates | Subject to dividend tax rates (which may be lower than income tax rates) |
Investor Expectations | Not predictable or expected regularly by shareholders | Expected and factored into investor income projections |
Growth Potential | Does not contribute to the long-term growth of a company | Provides a stable income stream but may not offer significant growth potential |
Frequency | Infrequent occurrence | Regularly scheduled distributions |
Decision-making | Driven by specific events, excess cash, or strategic considerations | Determined by company's dividend policy and financial performance |
It is important to note that special dividends should not be considered as a consistent source of income like traditional dividends.
Evaluating the sustainability of special dividends
A special dividend, almost by definition, is not sustainable. If a special dividend payment were sustainable, it would naturally be a part of the regular dividend program.
So while special dividends can be attractive in the short term, you need to consider whether these distributions are a sign that the regular dividend could be permanently raised or if it is just a one-off.
A thorough analysis of a company's financial statements, including revenue growth, profit margins, debt levels, and free cash flow, can provide insights into its ability to generate excess cash. A history of consistent dividend payments, both regular and special, is also indicative of a company's commitment to shareholder returns.
So while special dividends can be attractive in the short term, you need to consider whether these distributions are a sign that the regular dividend could be permanently raised or if it is just a one-off.
A thorough analysis of a company's financial statements, including revenue growth, profit margins, debt levels, and free cash flow, can provide insights into its ability to generate excess cash. A history of consistent dividend payments, both regular and special, is also indicative of a company's commitment to shareholder returns.
Dividend reinvestment options for special dividends
When receiving special dividends, shareholders have several options for reinvesting the funds. One option is cash reinvestment, where shareholders can choose to receive the dividend amount in cash directly. Cash reinvestment provides immediate liquidity, allowing you to allocate the funds according to your preferences, such as reinvesting in other investments or meeting personal financial needs.
You can also make the most of Pies and Autoinvest from Trading 212 to automatically reinvest any special dividends you receive. Instead of buying shares of just the company that issued the special dividend, you can distribute the extra cash across your entire portfolio, which keeps the weightings of each stock you own balanced.
Another option is participating in dividend reinvestment plans (DRIPs). DRIPs enable shareholders to use the dividend amount to purchase additional shares of the company's stock directly from the company, often at a discounted price. By participating in DRIPs, you can potentially accumulate more ownership in the company over time and benefit from the power of compounding.
It's important to consider the advantages and disadvantages of each reinvestment option. However, this decision should ideally be made before you get a special dividend, which usually comes quite unexpectedly.
You can also make the most of Pies and Autoinvest from Trading 212 to automatically reinvest any special dividends you receive. Instead of buying shares of just the company that issued the special dividend, you can distribute the extra cash across your entire portfolio, which keeps the weightings of each stock you own balanced.
Another option is participating in dividend reinvestment plans (DRIPs). DRIPs enable shareholders to use the dividend amount to purchase additional shares of the company's stock directly from the company, often at a discounted price. By participating in DRIPs, you can potentially accumulate more ownership in the company over time and benefit from the power of compounding.
It's important to consider the advantages and disadvantages of each reinvestment option. However, this decision should ideally be made before you get a special dividend, which usually comes quite unexpectedly.
Pros and cons of special dividends
This kind of direct payout offers several advantages for shareholders. On a personal level, just as if you received any other unexpected cash injection like an inheritance, they provide you with immediate access to additional funds that can be used for various purposes such as reinvestment, debt repayment, or personal expenses.
From an investment perspective, special dividends can lead to potential share price appreciation. When a company announces a special dividend, it often signals positive financial health and success, which can boost investor confidence and attract more buyers, potentially driving up the stock price.
However, it is important to consider the potential drawbacks of special dividends as well.
One potential disadvantage is the misinterpretation by investors. Since special dividends are often viewed positively, investors may misjudge the true financial health of the company based solely on the dividend announcement. This can lead to overvaluation of the stock, which may not be sustainable in the long term.
From an investment perspective, special dividends can lead to potential share price appreciation. When a company announces a special dividend, it often signals positive financial health and success, which can boost investor confidence and attract more buyers, potentially driving up the stock price.
However, it is important to consider the potential drawbacks of special dividends as well.
One potential disadvantage is the misinterpretation by investors. Since special dividends are often viewed positively, investors may misjudge the true financial health of the company based solely on the dividend announcement. This can lead to overvaluation of the stock, which may not be sustainable in the long term.
Additionally, special dividends can introduce volatility to the stock price. While the announcement of a special dividend may initially drive up the share price, the subsequent ex-dividend date can lead to a decline in the stock price as investors sell their shares to capture the dividend payout.
A company’s stock price should, in theory, automatically drop by the same amount as the special dividend on the ex-dividend date because the cash distribution represents a proportionate decrease in the company’s value. This market volatility can introduce short-term fluctuations and impact the overall portfolio performance.
A company’s stock price should, in theory, automatically drop by the same amount as the special dividend on the ex-dividend date because the cash distribution represents a proportionate decrease in the company’s value. This market volatility can introduce short-term fluctuations and impact the overall portfolio performance.
The opportunity cost of issuing a special dividend
While special dividends can provide immediate cash flow to shareholders, they also need to consider the opportunity cost associated with these distributions. Opportunity cost looks at the potential benefits lost by choosing one option instead of another. When dealing with a special dividend, the opportunity costs are any alternative ways the company's excess cash could have been used.
A company could always put its extra cash to work by putting it into research and development (R&D) initiatives, new product launches, expanding overseas or acquisitions of other companies. A return on these investments (ROI) can help grow the company and generate higher returns for shareholders in the long run. By opting for a special dividend instead, the company is limiting its ability to pursue these growth avenues, potentially sacrificing future profitability and shareholder value.
Debt reduction is another way a company can use its excess cash. Reducing leverage improves a company’s financial position, improves its creditworthiness, and potentially lowers borrowing costs. This provides more financial stability, especially during challenging economic conditions, than simply paying out a one-time dividend.
Another opportunity cost to consider is the potential for share buybacks. Share buybacks involve a company repurchasing its own shares from the market, effectively reducing the number of outstanding shares. This can have several benefits, including increasing earnings per share. By reducing the supply of shares, buybacks can create a favourable supply-demand dynamic, potentially leading to share price appreciation over time. In contrast, a special dividend does not reduce the number of shares outstanding and may not provide the same long-term impact on shareholder value.
A company could always put its extra cash to work by putting it into research and development (R&D) initiatives, new product launches, expanding overseas or acquisitions of other companies. A return on these investments (ROI) can help grow the company and generate higher returns for shareholders in the long run. By opting for a special dividend instead, the company is limiting its ability to pursue these growth avenues, potentially sacrificing future profitability and shareholder value.
Debt reduction is another way a company can use its excess cash. Reducing leverage improves a company’s financial position, improves its creditworthiness, and potentially lowers borrowing costs. This provides more financial stability, especially during challenging economic conditions, than simply paying out a one-time dividend.
Another opportunity cost to consider is the potential for share buybacks. Share buybacks involve a company repurchasing its own shares from the market, effectively reducing the number of outstanding shares. This can have several benefits, including increasing earnings per share. By reducing the supply of shares, buybacks can create a favourable supply-demand dynamic, potentially leading to share price appreciation over time. In contrast, a special dividend does not reduce the number of shares outstanding and may not provide the same long-term impact on shareholder value.
A real-world example of a special dividend
Costco (COST) has utilised the special dividend more than many other large blue-chip companies. It paid a special dividend five times in the span of eight years.
Year | Date | Amount per share | Total cost to the company |
2012 | November | $7.00 | $3.0 billion |
2015 | February | $5.00 | $2.2 billion |
2017 | May | $7.00 | $3.1 billion |
2018 | December | $10.00 | $4.4 billion |
2020 | December | $10.00 | $4.4 billion |
Past performance doesn’t guarantee future returns.
Costco was not the only company to issue a special dividend in 2012. Many companies were worried about a so-called ‘fiscal cliff’ for the US government. They tried to pre-empt this possibility by issuing extra dividends at the end of the calendar year (in December).
Costco was not the only company to issue a special dividend in 2012. Many companies were worried about a so-called ‘fiscal cliff’ for the US government. They tried to pre-empt this possibility by issuing extra dividends at the end of the calendar year (in December).
Source: Wall Street JournalStrategies to benefit from special dividends
Avoid chasing special dividends
Investors are often tempted to buy shares of a company when a large special dividend is announced. However, this strategy is typically not advisable. The stock price tends to decline by an amount equivalent to the special dividend after the ex-div date. This means gains made from the special dividend are offset by the fall in the share price afterwards, so it would not make sense to only participate in the fall afterwards.
Focus on sustainable dividend growth
Regular dividends, if done correctly, grow with a company's earnings, which is good for the long-term value of the company and the stock. Special dividends do not offer this same long-term benefit due to their one-time nature. Studies have shown that steady dividend growers tend to provide higher total returns over time, with the formula of dividend yield plus earnings growth being a reliable indicator.
Aim for top-quality dividend stocks
Rather than seeking out companies solely based on their special dividend payouts, it is arguably better to focus on high-quality dividend growth stocks that are in a good financial position to sometimes pay special dividends. Conduct thorough research to align your investments with your risk tolerance, time horizon, and financial goals rather than relying on the possibility of a special dividend.
Investors are often tempted to buy shares of a company when a large special dividend is announced. However, this strategy is typically not advisable. The stock price tends to decline by an amount equivalent to the special dividend after the ex-div date. This means gains made from the special dividend are offset by the fall in the share price afterwards, so it would not make sense to only participate in the fall afterwards.
Focus on sustainable dividend growth
Regular dividends, if done correctly, grow with a company's earnings, which is good for the long-term value of the company and the stock. Special dividends do not offer this same long-term benefit due to their one-time nature. Studies have shown that steady dividend growers tend to provide higher total returns over time, with the formula of dividend yield plus earnings growth being a reliable indicator.
Aim for top-quality dividend stocks
Rather than seeking out companies solely based on their special dividend payouts, it is arguably better to focus on high-quality dividend growth stocks that are in a good financial position to sometimes pay special dividends. Conduct thorough research to align your investments with your risk tolerance, time horizon, and financial goals rather than relying on the possibility of a special dividend.
Special dividends have tax implications that investors need to consider.
Tax treatment depends on your individual circumstances and regulations, which may change.
Here are some key considerations regarding the tax treatment of special dividends:
The tax rates applied to special dividends can differ from those applied to regular dividend payments. Some jurisdictions may tax special dividends at higher rates than regular dividends, while others may have specific provisions that allow for more favourable tax treatment.
In certain jurisdictions, special dividends may be subject to dividend withholding tax. This is a tax imposed at the source, where the company distributing the dividend withholds a percentage of the dividend amount and remits it to the tax authorities on behalf of the shareholder.
You are typically required to report special dividends as part of your annual tax filings. The dividend amount should be included in the appropriate sections of the tax return, such as dividend income or other income categories, as per your country’s tax laws.
You should consider consulting a tax professional to get a grip on the tax implications of receiving a special dividend in your country and under your circumstances.
Tax treatment depends on your individual circumstances and regulations, which may change.
Here are some key considerations regarding the tax treatment of special dividends:
The tax rates applied to special dividends can differ from those applied to regular dividend payments. Some jurisdictions may tax special dividends at higher rates than regular dividends, while others may have specific provisions that allow for more favourable tax treatment.
In certain jurisdictions, special dividends may be subject to dividend withholding tax. This is a tax imposed at the source, where the company distributing the dividend withholds a percentage of the dividend amount and remits it to the tax authorities on behalf of the shareholder.
You are typically required to report special dividends as part of your annual tax filings. The dividend amount should be included in the appropriate sections of the tax return, such as dividend income or other income categories, as per your country’s tax laws.
You should consider consulting a tax professional to get a grip on the tax implications of receiving a special dividend in your country and under your circumstances.
Recap
Special dividends are a unique way for investors to benefit from one-time payments outside of regular dividend distributions. But although getting a payment out of the blue might seem like a clear positive outcome over the short term, the long-term outlook for the company can be both positively and negatively affected by issuing a special dividend. Remember to assess the financial health, capture opportunities, and consider taxes to maximise the potential benefits of special dividends.
By examining real-world examples and the resulting trajectory of the stock price, understanding tax implications, and evaluating its meaning for future payouts, investors can best assess the consequences of any special dividend they receive.
By examining real-world examples and the resulting trajectory of the stock price, understanding tax implications, and evaluating its meaning for future payouts, investors can best assess the consequences of any special dividend they receive.
FAQ
Q: How are special dividends taxed?
In the UK, special dividends are treated as dividend income for tax purposes. They are subject to the same tax rates as regular dividends.
Shareholders are required to report special dividends as part of their dividend income when filing their annual tax returns. It's important for UK investors to stay informed about the specific tax regulations and consult with tax professionals for personalised advice regarding their tax obligations related to special dividends.
Shareholders are required to report special dividends as part of their dividend income when filing their annual tax returns. It's important for UK investors to stay informed about the specific tax regulations and consult with tax professionals for personalised advice regarding their tax obligations related to special dividends.
Q: Why do companies pay special dividends?
Companies pay special dividends to distribute excess cash to shareholders, often resulting from exceptional profits, asset sales, or favourable financial conditions. They can also be a strategic capital allocation decision, signalling financial health and a commitment to shareholder value.
Companies may choose to issue special dividends to optimise their capital structure, appease investors, or utilise surplus cash that is not required for growth initiatives or debt reduction.
Companies may choose to issue special dividends to optimise their capital structure, appease investors, or utilise surplus cash that is not required for growth initiatives or debt reduction.
