👋 everyone,
I first heard the word dividend when I was a kid playing Monopoly with my family. I wasn't sure what it meant, but I knew that I was going to get some money from the Monopoly bank, and that was enough to put a smile on my face!
You’ve probably heard dividends mentioned in the press or on your social media feed in relation to company stock performance or as an investment strategy but if you’re not a trader yourself, you might not be 100% familiar with how dividends work and the potential opportunities (and downsides) associated with dividend investing.
In today’s Concepts of Finance I want to demystify some of the terminology surrounding dividends so that the next time someone mentions it in conversation you’ll know a bit more about what they’re talking about.
We’ll explore the key terminology you need to know, how dividend investing compares with other forms of investing and we’ll also take a look at a hypothetical example together so that you understand the implications of investing in companies with high dividends.
Today I’ll cover:
What are dividends? A quick explanation
Why do companies pay dividends?
📹explanation
Examples of companies that pay dividends
Key terminology
A step by step guide using a real example
🛠️Useful tools
PS if want a refresher on stocks, these guide on how to read a stock chart and understanding stock options should help.
Quickly explained
Dividends are one of the ways companies reward shareholders. If you own stocks in dividend-paying companies, you can potentially earn a steady stream of income on top of any capital gains you receive when share prices increase.
This is why dividend investing is an attractive investment strategy for some people looking to escape the 9-5 and instead live on passive income streams. Sitting on a beach watching your bank balance increase after a series of successive company dividend payouts sounds ideal, but it’s sadly not that simple.
What are dividends?
A dividend is a distribution of a company's earnings to its shareholders. When a company generates net profit, it can either reinvest the earnings back into the business or distribute them to shareholders. Dividends represent the portion of profits paid out to shareholders.
Companies pay dividends on a per-share basis. This means if you own 100 shares of a stock trading at $50 per share and the company pays a $1 per share dividend, you would receive $100 in dividend income. Dividends are usually paid quarterly in the form of cash. Most dividends range from 1-5% of the share price on an annual basis. We’ll have a look at an end to end example together later
The most common type of dividend is a cash dividend but there are other types, too. Some companies, for example, will pay out a stock dividend which increases your overall equity or even a property dividend where a company will distribute some of the physical assets to shareholders. This is very rare but worth knowing about just in case.
Why do companies pay dividends?
At first it might seem strange that a company would choose to pay out a share of its profits to shareholders rather than reinvest that money back into the company.
Yes, we all want the companies we invest in to continue to be successful, but there are plenty of reasons why it makes sense for companies to pay dividends.
Here’s a few of them:
🤑Return profits to shareholders - Dividends provide a direct way for companies to pass along profits to their shareholders. Companies that have matured and have fewer high-return investment opportunities can return excess cash to shareholders through dividends.
💪Increase investor confidence - Consistent dividend payouts signal that a company is performing well financially and has stable earnings. This helps attract long-term investors looking for reliable income.
📈Improve stock valuation - Stocks that pay dividends tend to have higher valuations because dividends make the shares more desirable to own.
Dividends explained in 1 minute or less
Key terminology you need to know
The most important term to know about in relation to dividends is dividend yield. Just like property rental yields, this refers to the income generated expressed as a percentage. To calculate the dividend yield, use the following equation:
Dividend Yield = (Annual Dividend per Share / Stock Price) x 100
Other terminology worth knowing:
Payout ratio - The percentage of earnings paid out to shareholders in dividends. Used to gauge dividend safety and room for future growth.
Dividend Reinvestment Plan (DRIP) - Plans that allow shareholders to automatically reinvest dividends into buying more stock shares free of fees or commissions. Supercharges compounding.
An example
Let’s take a look at an example together to understand how dividend investing works.
Scenario: investing $1000 in Apple (AAPL) stock and estimating dividend income
(Note: as always, this is just an illustrative example and isn’t financial advice!)
We’ll assume the current Apple share price is $150. Apple’s dividend per share is $0.88 annually which gives us a dividend yield of 0.59%:
Current AAPL share price: $150
AAPL dividend per share: $0.88 annually
Dividend yield (0.88 / 150): 0.59%
With $1,000, you could buy 6 shares of AAPL (1000 / 150).
6 shares x $0.88 dividend per share = $5.28 in annual dividend income
$5.28 / $1,000 invested = 0.59% dividend yield
If you enrolled in Apple's dividend reinvestment plan (DRIP) to compound dividends over time:
Year 1: 6 shares x $0.88 dividend = $5.28 reinvested, buys 0.04 additional shares
Year 2: 6.04 shares x $0.88 dividend = $5.31 reinvested, buys 0.04 additional shares
Year 10: 6.63 shares x $0.88 dividend = $5.83 reinvested
At the end of our 10 year dividend investment we’d end up with an extra $55 in our pocket. Enough to buy a bottle of champagne to celebrate, but not much else.
And this is the tricky thing about dividend investing. Unless you’re dealing with bigger sums of cash, the upside can be limiting. In our Apple example, we’ve not factored in the potential growth of the company and stock performance - which, if it were to perform well, could outperform any returns you might get from dividends.
That’s why it’s important to choose companies carefully. Some companies pay dividends and some don’t.
Which companies pay dividends?
Here’s a list of the top performing stocks, ranked by dividend yield. These aren’t the sexiest companies in the world but they’re all solid companies with a proven track record.
If you’re assessing a company to figure out whether they might be a good dividend investment opportunity, some of the questions to ask yourself about the company could include:
Is the company established? A mature company might be less risky and able to maintain dividend payouts through tough economic cycles.
Does it have a strong balance sheet? Higher cash balances and lower debts can mean companies are able to continue paying dividends.
What’s its history of increasing dividend payouts? Some companies will increase their dividend payout amounts over time, some will keep it flat.
And of course, you should ask yourself the most important question of all: do I really care about dividends at all?
Some investors don’t worry too much about dividends and instead focus on investing based on company performance and the potential for the stock to increase rather than dividends.
As you can see from the examples, dividend income can be quite substantial once you’ve accumulated a lot of stock, but its limited upside can mean it’s not for everyone.
⚒️Useful tools
Dividend Reinvestment Calculator (DRIP Calculator) - Estimates how much your dividend investments will grow over time, taking into account the effects of reinvestment.
Investopedia Dividend Yield Calculator - Calculates the annual dividend yield of a stock.
Dividend Payout Ratio Calculator - Calculates the percentage of a company's earnings that is paid out in dividends.
Thank you very much for reading 🙏 if you found this helpful and enjoyed the post, I’d be super grateful if you could hit the ❤️ below - thank you!
DISCLAIMER: None of this is financial advice. Concepts of Finance newsletter is strictly for educational purposes.