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One-Time Special Dividends: Are They a Bad Sign?

By Hank Coleman

Beware of companies issuing special dividendsMany companies in the S&P 500 index are flush with cash as they economy starts to make a comeback and retail customers return to stores. In fact, the S&P 500 companies have over $800 billion in cash and cash equivalents on their books, and the number continues to grow as companies focus on cost-cutting measures, free cash flow, and protecting themselves from more market turmoil. There is so much cash on the balance sheets of companies that many financial analysts think that investors may see a resurgence of special one-time dividends. But, investors should beware of companies issuing these special dividends. While they may sound great in theory, they may not be the greatest thing for investors.

Special Dividends Don’t Offer an Arbitrage Opportunity

It does no good for an investor to chase special or even regular dividends when deciding when to purchase shares of stock. Many investors think they can buy a stock and hold it through the ex-dividend date (the date at which you must be the owner of the stock to qualify for the dividend) and then sell the stock the next day. The problem with this strategy is that the stock price will drop by the dividend amount that next day because the company will have lost value due to the reduction in its cash balance. Thus, what you gain in the dividend payout you lose in the reduction of the company’s stock price. So, for example, a company that trades at $20 per share and issues a one-time special dividend of $2 should be worth a price of $18 on the day after the ex-dividend date.

Special Dividends Are A Sign Of Lack Of Creativity

A special dividend signals to investors that the company cannot think of anything better to do with its available cash. For example, there may be no other profitable opportunities to grow the business, and that is why the cash as been piling up. This is exactly what happened to Microsoft a few years ago when it issued a special one time dividend and investors responded with a negative reaction. It is also similar to what investors are currently seeing in big technology companies like Google today who are slowing down and acquiring less companies because they’ve hit a growth peak.

Taxes On Dividends Are Set To Change

Currently, dividends are taxed at their lowest level in a very long time. Dividend income is only taxed at the 15% rate. But, that benefit is set to expire at the end of 2010 year unless it is extended by Congress, which seems unlikely. Future tax rates on dividend income could be considered ordinary income which means that dividend income could soar as high as almost 40% for the top income earners.

Final Thoughts

While there is room for stock dividends in every investor’s portfolio, you need to be aware of some of the risks. Dividends often show that a company is out of ideas and may represent a poor use of company funds. Also, when considering investing in a company that has announced a special dividend (or any dividend for that matter), remember that there is no “free money” to be had in the investment. The market is too efficient to allow for any kind of arbitrage opportunity. Lastly, the tax consequences can be huge for dividends.

What are your thoughts on one-time special dividends?

(photo credit: Shutterstock)

Hank Coleman
Hank is a freelance writer, entrepreneur, and professional in the government sector. He is also a personal finance writer who is currently studying for his Certified Financial Planning (CFP) credentials. He has a Bachelor's Degree in Business Administration and a Master's in Finance.

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Comments

  • http://thecollegeinvestor.com Robert

    I think it depends on the circumstances. I have owned Frontier Communications for years, and it is a utility. There is not much room for growth, due to heavy industry regulation, but it is a cash cow. It paid its first special dividend about 5 years ago, and has been paying a regular quarterly dividend ever since. I have since received total dividend payments in excess of the share price! I love being paid just to own the company!

    • http://www.moneycrashers.com/author/hankcoleman/ Hank

      Robert,

      You are right. Dividends are great. I love dividends from companies. I love being paid to wait for a company’s share price to improve. But, one time special dividends need to be taken with a grain of salt. I like to see companies issue one and then continue issuing quarterly dividends afterwards like Frontier that you mentioned. Microsoft is another company that did just that. The problem with Microsoft is that it is a cash cow like Frontier, but Microsoft cannot come up with much else to do with their free cash flow. They could be expanding, buying companies, coming up with new product lines, etc. But, no…they are just handing their profits back to their stock holders, and I think that is why stock holders have seen the company’s share price go nowhere for years now. In fact, shares of Microsoft are the same price and even a dollar less now than when it began issuing dividends in 2004.

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