What Is a Capital Dividend?
A capital dividend, also known as a return of capital, is a distribution made by a company to its investors, sourced from its paid-in capital or shareholders’ equity.
In contrast, regular dividends are paid out of the company’s earnings. Typically, a company opts to pay a capital dividend when its earnings are inadequate to fulfill a necessary dividend payment. This situation might signal potential issues within the company, as it implies that the business operations are not producing substantial earnings, or in some cases, any earnings at all.
Understanding a Capital Dividend
Capital dividends, often a signal that a company is struggling to generate earnings and free cash flow, are viewed as a cautionary indicator. These dividends are paid from retained earnings, potentially worsening the company’s situation by depleting its capital base and limiting future investment and business growth opportunities. Dividends are ideally distributed when a company is financially robust.
However, there’s a silver lining: in the U.S. and Canada, capital dividends are usually not taxable for the recipient. They’re seen as a return of part of the investment shareholders made when purchasing shares. Interestingly, a capital dividend payment reduces the adjusted cost basis of the stock for tax reporting purposes with the IRS.
In Canada, the term “capital dividend” can also mean a dividend paid from the proceeds of selling an appreciated asset. For instance, if a company sells a valued asset, it incurs capital gains tax. The non-taxed portion of the gains is transferred to a capital dividend account, from which shareholders receive a capital dividend.
Capital dividends are sourced from a company’s shareholders’ equity, calculated as total assets minus total liabilities. This equity represents the company’s net value, essentially the amount that would be returned to shareholders if all assets were liquidated and all debts cleared.
Capital Dividend vs. Regular Dividend
Traditional dividends are essentially a portion of a company’s profits, and they can be distributed in various forms such as cash payments, additional stock shares, or other types of property.
The decision regarding the form, amount, and timing of dividend payouts is made by the company’s board of directors. These distributions typically occur monthly or quarterly. Additionally, the board may choose to issue special dividends, either on their own or in conjunction with a regular dividend schedule.
Dividends serve as a form of profit-sharing and act as a reward for shareholders who have invested in the company. The ability to pay dividends often signals that a company is well-established and generating a consistent stream of free cash flow.
Conversely, startups and high-growth companies usually do not offer dividends. Instead, they reinvest their profits into research and development to fuel further growth. This is particularly common in the technology sector, where startups often incur losses in their early years, rendering them unable to distribute dividends.
Dividend Payers
Larger, more established companies with steady and predictable profits are often the best dividend payers. Examples include well-known firms like 3M (MMM) and Coca-Cola (KO). The dividends these companies offer act as an incentive for investors to purchase and hold their shares, especially since their stocks typically don’t experience significant gains or losses in the market.
Investors who focus on dividend-paying stocks usually follow a dividend investing strategy, as opposed to a growth-oriented approach. Historically, companies known for paying dividends are often found in sectors like utilities, basic materials, oil and gas, financials, healthcare, and pharmaceuticals. Many of these dividend-paying entities are blue-chip companies, which, while offering dividends, may show little in terms of stock price appreciation.
Additionally, certain types of investment vehicles like Master Limited Partnerships (MLPs) and Real Estate Investment Trusts (REITs) are also recognized for their high dividend payouts. These entities are structured in ways that often allow them to distribute a significant portion of their income as dividends to investors.