Dividends are one way a company rewards its shareholders. They can also be the basis for powerful investment strategies.
You see a lot of talk on this site about dividends. Well, what are dividends? I take it for granted that everyone knows the ins and outs of what dividends are. So let’s zero in on this fundamental concept of investing. It’s something I focus on a lot in my investing and want you to share the same depth of knowledge and love for dividends!
What is a dividend?
In its simplest form, dividends are how corporations share their profits with the owners of the company. That’s right – if you own a share of stock, you a part-owner of that company. It might not feel like it since you’re not making day-to-day decisions for the company, but if you bought enough of that company’s stock, you would get a seat at the table and your opinion would have a lot of weight. In the meantime, 100 shares of AT&T (T) would make you an owner of about 0.0000016% of the company!
As infinitesimal as that percentage is, it still entitles you to that portion of the company’s profits.
Seeing yourself as a part-owner of a company versus an investor also puts you in the right frame of mind for your long-term investment strategy.
Why do you receive a dividend?
So how does the company reward you, the owner? Three ways:
- Directly, by giving you part of the profits in cash as a dividend for each share of stock you own.
- Indirectly, by plowing the profits back into the company to increase its growth. The company’s value should go up with increased growth, which would make your shares of stock increase in value.
- Indirectly, through a stock buyback. The company commits to buying stock off of the market, reducing the number of outstanding shares. Even though you own the same number of shares, those shares would now represent a larger ownership percentage of the company. As an example, if AT&T bought back 1 billion shares, your 100 shares would now make you a 0.0000019% owner!
Martin, why do you focus on dividends if there are two other ways the company can pay you? I’ll tell you why – A dividend doesn’t rely on that company’s future success. I get the dividend and can reinvest it in whatever other investment I think has the best value at that time. Or I can take it and pay my cell phone bill. Yes, I like the irony of AT&T’s dividend paying my phone bill!
Plowing the profits back into the company could pay off, but it usually takes years for that to be reflected in the profits of the company (and therefore our stock price). This is the most common strategy for growth stocks. Lots of companies show incredible growth, and their stock prices skyrocket because of it, but it’s a much bumpier ride than consistent dividend-paying stocks. The growth strategy also might not pay off at all, which means the company wasted the money when they could’ve paid you directly.
Stock buybacks aren’t bad, but there’s ample evidence companies don’t employ the strategy at the right times. If they buy back stock while it’s at a high price they are not going to buy back nearly as many shares as they would during a downturn. And that makes sense since most companies are tight on cash during downturns. A dividend would give me better value versus buying back stock after a runup in price.
How do you know what a company’s dividend will be?
Once a company decides to reward its owners by issuing a dividend, they will state it as a flat dollar amount. The officers at AT&T are going to say this quarter’s dividend is $0.50 per share. AT&T’s officers don’t say “this year’s dividend yield will be 6%”. They can’t because that yield will change every day as the stock price changes. They may have a target yield in mind, but they will always announce the dividend in dollar amounts.
That means during a downturn where stock prices are dropping, the dividend is still going to be the same $0.50 per share. My income isn’t going to take a hit just because the stock price went down. The company would have to purposefully decide to lower their dividend payout; they will avoid doing that if at all possible because it would send major red flags to the market that the company is in trouble.
We investors convert that dividend amount into a yield percentage so we can compare it to other company’s dividends. A $2 dividend (50 cents per quarter) on a $32 stock is quite attractive at a 6.25% yield. That same $2 dividend on a $100 stock is a very ordinary 2% yield.
Will I receive the dividend if I just bought the stock?
There are several dates to be aware of when buying dividend-paying stocks.
Announcement date: I referenced this above when the company’s board of directors get together and confirm how much the next dividend will be.
Ex-dividend date: This is the date where you will no longer receive the next dividend if you buy the stock. It takes a couple days for trades to settle, and at this point your trade won’t settle in time for you to be the owner on record for those shares. The good news is the stock price will drop by the exact amount of the dividend on this day, so you won’t be paying for a dividend you don’t receive.
Record date: Whoever is on record as owning shares of stock on this date will receive the dividend.
Here’s how to keep it easy: if you buy a stock before the ex-dividend date you receive the dividend. If you purchase on or after the ex-dividend date you don’t receive it. These dates only matter when you are purchasing or selling shares. If you’ve owned the shares for a while you will receive any dividends the company pays out.
Anything else about dividends that will help your investment strategy?
Another reason to love dividends is that if a company can pay that cash out, it means it has consistent positive cash flow! That’s a sign of a healthy company. The company is also going to work very hard to never have to cancel or lower that dividend because of the negative PR hit they would take. That means a company is going to make sure its future cash flows are steady enough to support that dividend for years to come. Another great sign of a healthy company you want to invest in.
Hopefully, that sheds some light on what a dividend is and why it is important to you.