DR 096: Dividend Investing (Part 1)–What are Stock Dividends?

One of my favorite aspects of investing is receiving a dividend payment. Each month I look to see how much I earned in dividends, and I track this amount yearly.

In fact, dividends play a significant role in my investment policy related to individual stocks. With the exception of Berkshire Hathaway, every business whose shares I own pays a dividend. Given their importance, a series on dividend investing seemed appropriate. This article is the first one in the series.

What is a dividend?

Dividends are a payment by a company to its shareholders of a portion of the company’s profits. Think of a dividend as an investor’s chance to reap the benefits of a company’s profitable performance. While dividends can be paid in stock, that is unusual. Dividends are typically paid in cash.

Typically, and I stress typically, dividend payouts follow the following guidelines:

  • Dividends are typically paid to shareholders once each quarter
  • The amount of the quarterly dividend payments is typically set by management and the board once a year
  • For the largest most solid companies, dividend payments typically (hopefully) rise each year

Many investors not in retirement automatically reinvest their dividends back into the stock, mutual fund or ETF that generated the dividend. In this regard, dividend payments are invisible for many investors.

Pop Quiz: Do you know how much in dividends your investments generated last month? Year to date? Last year? That’s just one of the things I love about Personal Capital. The free investment tracking tool makes it a snap to see how much in dividends your investments generate.

Why do Companies Pay Dividends?

And all of this raises an important question. Why do some companies pay a dividend while others do not?

There’s no one answer to this question. For those companies without dividends, the reason is that they need the capital to grow the business. Amazon and Tesla are two examples of well-known companies with no history of payment dividends who are reinvesting their cash flow back into the business.

Other companies, like Berkshire Hathaway, do not pay a dividend for an entirely different reason. As Warren Buffett has explained, Berkshire doesn’t pay a dividend because Buffett and his team can invest the cash an earn a nice return for investors. If shareholders need some income, they can sell some of their shares rather than wait for a dividend payment, which is unlikely under Buffett’s watch.

In the darker corner of the world of public companies, some enterprises do not pay a dividend because of mismanagement. CEOs at some companies have an appetite for big, costly acquisitions and share buybacks that often squander shareholder value.

On the flip side, those companies that do pay a dividend typically do so because the business earns more cash than the company needs to maintain its existing business or reasonably expand into new business lines. Many of the companies are household names like Ford, P&G, Apple, and Microsoft.

How do you determine the amount of a company’s dividend?

Now that we know what dividends are, how do we figure out how much a specific company pays in dividends? The easiest way to do this is to use a finance website such as those offered by Google, Yahoo, or Morningstar. Unfortunately, it’s not quite as easy as that.

If you look at these sites with a focus on a specific company, you are likely to see different amounts for the payout and even different values for the dividend yield (yearly dividend / share price). For that reason, I encourage you to watch the video below where I walk through how to use these sites to get information about dividends and the podcast.

Dividends vs. Interest

At first glance, dividends seem an awful lot like interest payments from bonds. Upon closer scrutiny, however, we quickly realize they are as different as lightening and lightening bugs.

Here are the key differences:

1. Issuers of bonds are contractually required to make the interest payments. Failure to make the required payment timely is a default under the bond agreement. There is no such obligation on the part of companies to pay dividends (at least on the common shares; preferred stock is another matter entirely).

2. Interest payments are typically paid in fixed amounts. Dividends can increase or decrease based on the performance of the company and management’s dividend policy.

3. The par value of bonds does not change. If you buy a $10,000 bond and hold it to maturity, you’ll receive your $10,000 investment back. With stocks, there is no maturity date and the value of shares fluctuate daily. (I should not that the value of bonds fluctuate as well, but not par value or what an investor would receive at maturity.)

The next article in this series will cover key metrics used to evaluate a company’s dividend policy.

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One Response to “DR 096: Dividend Investing (Part 1)–What are Stock Dividends?”

  1. I have thought a bit on how to allocate a present value on an pension or annuity. Multiplying by 15 is easy. But that correlates to a 5.5% rate for 30 annual payments. I think I would correlate it to market interest rates and the length of time you expect to receive the payments. Say you can get an annuity at a 2% rate and you retired at 45 and expect to live to average live expectancy say to 81. Then the multiplier would be about 25x. Now about determining how much to allocate. To me allocation is a risk management feature. Say I need 50K per year and I get a 35K pension. There is 15K per year shortage that must come out of my savings and investments. One rule of thumb I learned while reading around is not to have in the stock market any money you need within 5 years. I think this comes from Motley Fool but I like the concept. I think that Morning Star (Christine Benz’s portfolios) keeps about 2 years in cash, plus the next 8-9 years in bonds and the remainder in Stocks. These have an anticipation of a stock market risk that needs to be considered above a general percentage rule. What if my pension my 40% bond allocation therefore I’ve put all my money in stocks and then the crash occurs. Now the 15K per year shortage is going to be very expensive against my portfolio until the market recovers. But if I’ve considered my cash needs and the length of time for market recovery, I have also set aside 2, 5 or maybe 10 years of cash and bonds and made them available in case the market crashes and I need time for recovery. To do this you have to understand your risk tolerance. I think 10 years is a very weak risk tolerance but to do so you would have 10 years of cash, laddered bonds and CD’s lined up just in case. If we are OK to settle on a ‘rule of thumb’ allocation then maybe we don’t understand our own personal risk and need to dive a little deeper into our finances.

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