Dividends
What are dividends?
People hold stocks because over long periods of time, the stock market tends to go up, increasing the value for all participants. But there is one more important reason to invest in stocks: dividends. Some companies’ management teams want to remunerate their owners (their bosses i.e. you), more than just by working hard to make the company’s stock price go up. And they do this by paying the company’s owners, shareholders (i.e. you) dividends. These are regular payments, typically quarterly, that the company makes to all its shareholders. Let’s take the example of GlaxoSmithKline, the very large British pharmaceutical company and one of the largest pharma companies in the world. At the time of writing, it pays a quarterly dividend of 19 British pence per quarter. This means if you own 100 shares of Glaxo, every quarter, the company pays you 19 pounds (19 pence * 100 = 19 pounds). This is about GBP 72 per year, that you earn just for holding 100 shares of this company.
Why do companies pay dividends?
Dividends used to be a lot more common than they are now — nowadays shareholders tend to focus and expect a lot more share price increases. But there used to be a time when shareholders certainly expected many of the companies in their portfolio, companies with excess profit, to pay them dividends also. I would say companies pay dividends for a variety of reasons:
1. They have excess profits, and while they use part of those dividends to reinvest and grow the business, they also use part of them to remunerate their owners through dividends
2. Because their growth prospects and price appreciation is not nearly as high as hot fast growing companies, they pay regular dividends to their owners to incentivize them to buy and hold their shares — in a way they say to you “my stock cannot grow as fast as Google/Alibaba/Tesla etc., but look I will make these regular payments to you to make it up a bit for my slower growing stock price.”
3. Because they enjoy highly stable revenues, and have stable earnings. They can “easily” pledge to regularly pay their owners dividends in this case. This is why it is common for utility companies (national electricity companies for example), to pay nice dividends to their owners.
Overall, I would say mature companies, that have finished their high growth period and therefore don’t need to reinvest all their earnings, and enjoy stable profits, can and often pay dividends. Many industrial stalwarts of the stock market, stocks like IBM, 3M, banks, pay dividends.
On the other side, fast growing companies that reinvest all their earnings to support their fast growth, highly coveted companies that many shareholders want to own just for the expected share price increase, and companies that are in difficulty and don’t generate any excess earnings to be able to pay dividends, tend not to pay dividends. These include on the one hand high flying tech stocks like Google or Facebook, and the other hand companies undergoing extreme difficulties.
Dividends are sticky
The good news is that dividends are sticky: companies that pay regular dividends tend to continue paying regular dividends, and the amounts tend to change slowly over time as opposed to drastically from one quarter to the next. They also tend to follow earnings, meaning that if you check a company’s projected earnings, you can have some sort of forewarning if it will decrease its dividends i.e. if you see the company’s earnings plummet from one quarter to the next, you can wonder if the next quarter the company will also decrease its dividends.
Over longer periods, dividends, like the world, can change of course. For example more than a decade ago, in December 2009, GlaxoSmithKline was paying 61p in quarterly dividends. This means if you owned 100 shares the company’s management was paying you 61 pounds per quarter or 244 pounds per year for being a co owner of the business. So over the past decade this company reduced its dividends from 61p per share per quarter, to 19p per share per quarter. Why? Maybe so many investors want to own its stock that it does not need to pay them a high dividend anymore. Maybe it is going through a difficult period so it cannot afford to pay dividends at the moment. Maybe it has great growth projects to invest in internally with the money that it used to pay in dividends. If you are not happy with this, you can sell their stock and buy another company that gives you higher regular payments.
I will point out here however that management teams are very reluctant to lower or change their dividends — even when companies face difficulties, they will do their best to maintain their dividends to their owners. As we said dividends trail earnings, meaning it usually takes a quarter or more even for a company in difficulty to significantly change its dividend policy.
Two metrics to know:
We look at dividends following two metrics:
1. Dividend yield. This is simply the annual dividends the company pays, divided by its share price. i.e. how much of the total value you invested in this company (price per share x number of shares you bought = your total holding), will it pay you in dividends. This also allows you to know the absolute amount in dollars, that you will receive in dividends from your investment in this company.
2. Dividend payout ratio (often referred to simply as payout ratio). This is simply the annual dividends the company pays, divided by its annual earnings/profits. i.e. what percentage of its total profits does this company pay its shareholders as dividends.
Let’s try these together for IBM:
We see that the company’s dividend yield is of 6.52, or 5.4% given its price per share of 119.84. This is a relatively generous dividend yield nowadays. And we see that the payout ratio is 51%, meaning of all its annual earnings/profits, the company gives back to its owners more than half. What does it do with the rest? Probably (hopefully) reinvest them wisely in order to grow and improve its business, and price per share. Again, this is a high payout ratio. IBM is a mature and stable business, its fast growing phase is now long behind, and the business generates regular excess profits. It makes sense for a company like this to return some of these profits to its owners in the form of dividends.
Let’s look at some examples among US companies:
As you can guess, some investors make very nice quarterly cash simply by holding such dividend paying companies. I know investors who after a while manage to live simply off their dividend payments — any appreciation in the company’s stock is simply bonus from then onwards!
How? Let’s assume your total investment portfolio, for some of us this could be our entire savings/pension fund, is 1.000.000 USD. Let’s assume you use this money to buy a portfolio of stocks that all pay dividends, with an average of 6% dividend yield per year. What this means is that every year, you will receive 6% of your total investments (1.000.000), as a dividend, paid every quarter. In total, you will receive 60.000USD per year in dividends, for being an owner / shareholder of these companies, paid in four quarterly installments of 15.000 USD each. This is not bad — a lot of us could certainly simply live from such dividends, without ever touching our savings! An investment account of 1.000.000 sounds like a lot, but in countries where you have access to your pension partially or in its entirety, having a large total investment account is not that difficult.
Where do dividends come from?
Dividends are simply part of a company’s earnings or profits. Some companies consider they don’t need to pay their shareholders anything, because they hold their stock only because they want it to appreciate in value over time. Other companies, either because they have large excess profits, or because they have very stable profits, or because on the contrary they are undergoing a difficult period and want to incentivize their shareholders to continue holding their shares and not sell, pay regular dividends from their earnings. The company’s management has a policy at this level, and announces publicly, that it will pay part of its earnings this quarter, to its owners/shareholders. And every quarter it announces this openly and publicly, so it is very easy to know this.
Four dates to know
If you are a long term investor you don’t need to worry about this, but here are the four important dates regarding dividends:
- the dividend declaration date: this is when the company announces its intent to increase, decrease, or hold the same, its dividends. It does this every quarter if it pays quarterly dividends.
- the ex-dividend date: this is the date by which you need to be a stockholder, in order to receive a dividend for the previous quarter. If you buy stock after this date, you will need to wait until the next quarter to earn a dividend
- the holder of record date: this occurs a few days after the ex-dividend date, and it is simply when the company makes a list of all its shareholders who were holding the stock before the ex-dividend date, and who will therefore receive a dividend
- the payment date: this is when the company actually pays the dividend to its owners
How are dividends paid?
Dividends are paid automatically by companies to their shareholders. You don’t have to do anything — other than check and make sure you received your fair share! In practice, your investment broker/bank will process, receive these, and put them in your account, automatically for you.
