What Are Dividends?

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Dividends are one of the central rewards of investing in equity markets.  In some of the most fundamental methods of valuation, a company’s stock price can be valued simply by how large a dividend per share the company pays, and how reliable that dividend is.  Even companies that choose not to pay a dividend to their shareholders can find their stock prices being valued as if investors are asking themselves “how large a dividend could they theoretically pay, if they chose to…”.

So, in other words, even when dividends do not exist, they are being considered.  This would indicate a necessity to maintain at least a basic understanding of dividend paying stocks.

In order to understand dividends, it is important to take a short step back and review the role of stock/shares in a company.  When a company needs to raise money for expansion, research and development there are a couple of ways it can do so.  It can get a loan from a bank, or it can make an offering of shares. If the company takes out a loan, then this typically necessitates paying some form of regular interest plus the loan amount back at the end of the term.  Should the company decide to raise capital by selling shares, there is no interest or principal obligation as is the case with a bank loan, but the company has now in a sense sold a piece of itself to the new shareholders.  With this comes an obligation to shareholders, such as the company directors’ legal obligation to do all in their power to maximize shareholder wealth.  One way to do this is to make a payment to shareholders.

Simply, dividends can be viewed as the company sharing profits with its shareholders. If a company makes $100 Million profit this quarter, and has 10 Million shares outstanding, this would indicate that the company made $10 profit per share.

A big decision the company directors must make on a regular basis is: “what to do with profits?”…

  • Should they use the money to re-invest in, and grow the business?
  • Should they pay back some existing loans to reduce their debt?
  • Should they pay a large dividend to shareholders?

Commonly, they do a combination of all of the above. Continuing from the previous example, let’s say the company decides to, from the $10 profit per share (referred to in financial jargon as Earnings Per Share, or EPS), pay a $2 dividend.  Anyone who owned the stock on the “ex dividend date will then be entitled to receive the dividend.

This may seem like a nominal amount, but what if you owned 5,000 shares in the company? What if the company pays a dividend every quarter? What if the company tends to steadily raise the dividend each year? The chart of the stock price could stay flat and you would still be making $40,000 per year just from the dividends.

This number can help determine a stock’s “dividend yield”.  The yield is simply the annual dividend divided by the current market share price.  So, in the example above, the company pays a $2 dividend each quarter, so that would mean $8 per year.  If the market price of the stock is $200 per share, then that would mean the company has a 4% dividend yield (8 / 200 = 0.04 = 4%).  If the market price were just $100 per share for the same dividend, then it would have an 8% dividend yield (8 / 100 = 8%).  An 8% yield would be attractive, given that the historic average for dividends is a 4.41% yield.

This sort of thinking opens up an entirely different view of the stock market. Rather than the daily back and forth of news headlines full of superlatives focusing on up or down, an investor is able to take a more metered logical approach, focusing on the big picture.  Serious long term investing is about accumulating assets.  As the classical wisdom goes: “In the short term, the stock market is a voting machine. In the long term, it is a weighing machine”.

Rather than looking at the stock prices and trying to make a decision based on the ups and downs, try focusing on the dividends for a little while.  How regularly are they paid? Are the dividends coming from current profits? Or, is the company on its way out, and just distributing excess cash from previous years’ earnings?  Perhaps the company is steadily increasing its dividend? Often a fund or asset manager will spend a portion of his time keeping track of the best dividend stocks in any particular market sector or global region.

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That being said, it can be quite difficult and time consuming to even begin to do the proper due diligence required to select the right companies and build a suitable portfolio for the investor’s unique circumstances.  As mentioned above, dividends are not like interest on a loan; the company is not required to distribute profits to its shareholders.  Also, if a company starts losing money, or goes into bankruptcy, the shareholders could see the value of their shares drop dramatically (even to zero or close to it); along with their hopes of receiving a dividend any time soon.  The company CEOs will also need to keep in mind the current tax on dividends, and if it makes sense to instead reinvest the profits into the company rather than pay a dividend.  Whether the investor would even want a dividend himself also depends on their personal tax situation, and if they are making use of any tax planning strategies.

Once you decide to start incorporating dividend paying companies into your portfolio you next need to consider how best to diversify and spread risk. Collective investment instruments are in no short supply so the question is: which dividend strategy to choose?

What Are Dividends?
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What Are Dividends?
What are dividends? Why are they important? How do I receive them?
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