My third post is going to be about Dividends. As we talked about in my first post, Compounding Snowballs, Dividends are very important to compounding. When I first learned about Dividends I only cared about two things, when I would get paid and how much. I can give you answer to both. You usually get paid four times a year, every quarter or once every three months. To figure out how much let’s use another Lemonade Story.
Farhang and his wife Kristin are both interested in becoming shareholders of the lemonade stand. Lily and Sara created four shares. Each member of the family gets a quarter of the lemonade stand.
Kristin wants to know after investing, how much will she get as a dividend? Lily and Sara tell their mother that they will pay 40% of their earnings as a dividend. Meaning each shareholder will get 10% of their profits. Farhang was confused by this metric so he asked his daughters to explain their reasoning.
“There are four shares sold. To become a shareholder you have to pay $2.00 per share,” Lily explained.
“We decided that we want to pay 40% of our earnings back to you. If we earn $2.00, our profits, and took 40% of that it would come to $0.80 total,” Sara added.
Lily chimed in and said, “Then we had to divide the amount of shares we have, 4, by the total amount of dividends paid, $0.80, which would give us a $0.20 dividend. If you divide $0.20 by $2.00 you get 10%, which is your dividend.”
Later in the lemonade season, Farhang was grateful for his daughter’s explanation and enjoyed his $0.20 dividend.
Here are a few important things to know about Dividends.
1) Companies try to pay their shareholders Dividends in tough times. This sounds nice, but it is a little troubling and here’s why. Dividends are paid from the company’s profits and if the company doesn’t make enough money and still are committed to paying they get into to serious problems with debt. Most small companies don’t pay Dividends because it’s too much of a risk or they want to use the money to grow.
If Elise owns a small store that has local customers that come every Monday and Friday but then a new Whole Foods with cheaper prices is built across the street. No matter how loyal you think they are if Whole Foods has better prices they will walk the bridge to the other side. Now Elise is stuck, she has to pay her shareholder’s Dividends off of the smaller set of customers that visit her store not the steady income of all of the locals. That’s one reason why most small companies don’t pay Dividends, and if you look at the market there aren’t a lot of large business, it’s mostly made up of small companies.
2) Many large companies do pay a Dividend. They are more stable and more developed as a whole. That said it’s still at risk, for the most part, let me stress it depends on the company. Always do your own research and figure out what you’re comfortable with. Johnson and Johnson for example has grown their Dividends every year for 53 years.
It’s really important to know how much money of the company’s profits are spent on Dividends. This metric is called the Dividend Payout Ratio or just Payout Ratio. First, we will learn how to calculate it and then what it is and why it’s important.
If Josie wanted to invest in Johnson and Johnson (ticker: JNJ), she would want to know how much of their profits they spent paying their shareholders. As you can see the Payout Ratio is 56.8%, that means over half of their profits are spent on Dividends. As an investor you have to decide for yourself what’s too risky. Johnson and Johnson is a very successful company and has had a higher Payout Ratio it hasn’t seemed to affect them yet but I would watch the Ratio very carefully to make sure it doesn’t get too high.
I’m sorry this took so long to write, as most know when school starts everyone's life gets at least 50 times more busy. I’m going to try to post at least once a month, from now on.