Trillionaire Term of the Day - January 8, 2009

Dividends

Dividends are payments declared by a company and given to its shareholders directly out of the company’s earnings. The payments are usually given as cash or as more shares in the company.  While companies are not required to pay dividends, it is usually seen as an advantage by investors because it is a stable and reliable source of income. 

As a basic example to explain how dividends work for an investor, we will use “Investor A” and “Company B”.  If investor A has 1,000 shares of Company B at $10 per share, then Investor A has $10,000 invested in Company B.  If company B pays a dividend of $0.50 per share (a 5% dividend yield), then Investor A will receive $500 per year strictly from Company B’s dividend ($0.50 per share X 1,000 shares).  

I am going to use Motorola (MOT) to show how dividends work in a real-world example.  Motorola is currently trading at $4.53 and has a dividend of $0.20 per share (a 4.41% dividend yield).  If you owned 10,000 shares of Motorola, you would have $45,300 invested in the company.  Every year, you would receive $2,000 from the company directly from the dividend payment ($0.20 per share X 10,000 shares). 

Dividend yields are also very useful when analyzing a company’s dividend payout.  Dividend yields, which are percentages, describe the rate of return you receive on your investment strictly from the dividend payout.  Going back to the Motorola example, if you invested $45,300 in the company and received $2,000 annually from the dividend, you would be getting a 4.41% yield. The easiest way to figure out the dividend yield is to divide the dividend per share by the stock price.  In the Motorola example, you would divide $0.20 by $4.53 to come up with a yield of 4.41%.  One interesting thing to note is that as a stock’s price increases, its dividend yield decreases even though its dividend payment remains the same.  On the other hand, if a stock’s price drops, its dividend yield increases because the numerator in the equation stays the same while the denominator gets smaller (it is simple algebra). 

What do companies do with their surplus profits? Some companies use their surplus incomes to fund new projects that will boost their growth.  Companies that focus more on growth usually do not pay dividends, as they use the excess money for research and expansion purposes.  The rationale of not paying a dividend is that investors will receive greater returns on their money if the company they invested in finds ways to grow its business by using its excess profits in productive ways instead of paying them back out to the investors in quarterly payments. 

In times of economic weakness and recessions, dividends become extremely desirable.  Not only do dividend yields greatly increase because of decreased stock prices, but dividends are reliable payments and sources of income for many investors.  No matter what happens to Motorola’s stock price in a recession, it will continue to pay out $0.20 per share to investors. That is enough for many investors to stay in the game, even in today’s unpredictable market.

 

Niki Pezeshki

College Trillionaire