What Is a Dividend?
And Why You Should Care About Them
You might not know what a dividend is exactly, which is not your fault. Item #7 on my “30 things I learned about money before 30” post touches on how our education system has failed us when it comes to money and personal finance. I recall spending countless hours learning how to measure geometric space, how to calculate velocity and many other interesting facts and lessons, none of which have ever helped me earn any money.
If you are interested in more “finance 101” topics, check out my article on Bonds, Mutual Funds, & Index Funds.
Now, onto the question of the day.
What Is a Dividend?
Put simply, a dividend is a sum of money that a corporation pays to its shareholders. These payments which come from either the corporation’s profits or reserves are paid out on a regular basis (often quarterly).
Why would a corporation pay you money to invest in their company? Isn’t the whole point of investing in stocks to make money? To understand why corporations pay dividends, consider the fact that as an investor you have limitless options of where you can invest your money. There are thousands of individual stocks, mutual funds not to mention non-stock related investments such as bonds or real estate.
Companies pay dividends to investors, in part to incentivize you to choose their company to invest your hard-earned money!
How Do Dividends Work?
Let’s, say you buy one share of company “A” (yay! you are now officially an investor) for $100. Throughout the year, Company “A” pays you $1 in dividends. This means that Company “A” pays what is called a dividend yield of 1%. Dividend yields are used to give an investor an idea of how much dividends they will be paid relative to the share price of a company. It is calculated as follows:
Annual dividends per share ÷ Share Price
In the above example, of company “A” we calculate the dividend yield by dividing the $1 in annual dividends by the share price of $100 to reach a dividend yield of 1%.
Compounding
You might be saying “Whoop-de-do dividends of a few dollars per share, that won’t make any impact on my wealth.” You would be dead wrong. By simply reinvesting your dividends by purchasing even more units of the stock you will grow your wealth massively overtime by dramatically increasing the number of stocks you hold and the dividends you collect on an annual basis.
Do not take it from me. Consider the incredible impacts that dividend reinvestment can have on your long-term gains, using this S&P 500 historical returns calculator.
If you invested $10,000 into the S&P 500 index in May 1988 and did Not reinvest the dividends and simply pocketed the extra cash, that initial $10,000 investment would be worth $96,260 today. Not too bad!
But consider this, if you reinvested all the dividends you received over that time period, that same $10,000 invested in 1988 would be worth $191,579 today. You would essentially double your profits by simply reinvesting your dividends.
This is example demonstrates the power of compound interest: small gains constantly reinvested produce explosive growth over long periods of time.
Don’t Be Fooled by High Dividend Yield
You may be tempted to go out and look for stocks with the highest dividend yield you can find. I mean why not? I just told you how amazing dividends are. I would advise extreme caution for 2 reasons:
- As I have stated in past posts, I firmly believe in passive index investing rather than picking individual stocks and;
- High dividend yield is not always a good thing.
let’s refer back to the equation to calculate dividend yield: Annual dividends per share ÷ Share Price
a higher dividend yield could be achieved by increasing the dividends per share but a drop in the share price could also increase the dividend yield. Remember Company, “A” had a $100 share price and paid $1 in dividends for a dividend yield of 1%
What if I told you next year Company “A” would have a 2% dividend yield? You might think that’s awesome! $2 in annual dividends instead of $1. While that is possible, it’s also possible that the share price dropped from $100 to $50, company “A” still paid out $1 in dividends over the year for a dividend yield of 2%. The following year, the company “A” may decide to cut its annual dividends. The point is, do your homework and don’t let dividend yields drive your investment decisions.
That covers off some of the basics of dividends, hope you found this helpful!
This article is for informational purposes only, it should not be considered Financial or Legal Advice. Consult a financial professional before making any major financial decisions.
