One of the most frequently asked questions in Advantexe’s business simulation-centric workshops is, “Can
you explain the impact of giving or not giving dividends?”
To help participants in our Business Acumen programs I wrote this blog that I am pleased to share with our blog and business community. I start the blog with a definition of what a dividend is and then share insights about the impact of the dividend on a company and its shareholders.
What is a Dividend?
A dividend is a way to share a portion of a company's profits with its shareholders. Shareholders have trusted a company with their capital (cash) and if a company does well, there is an obligation to share the success with the shareholders who gave the company the cash to do business.
The distribution of dividends is typically a big deal and is approved by the Board of Directors. Dividends are often paid quarterly, and sometimes instead of cash, dividends are given in additional stock.
One of the most important metrics of success when it comes to a dividend is something called the “dividend yield.” The dividend yield is calculated by dividing the actual dividend by the current stock price. For example, if the annual dividend is $10 ($2.50 per quarter) and the stock price is $200 per share, the dividend yield is $10 divided by $200 which equals 5%. That, of course, is over and beyond the increase (or decrease in the value of the stock). A blog for another day is the concept of Total Shareholder Return (TSR) which looks at the increase/decrease of the value of the stock plus the added value of the dividends.
For investors, dividends can provide a steady stream of income and can also be a sign of a company's financial health. For example, retirees who have invested in a portfolio of stocks that give regular dividends may actually live off of their quarterly dividend disbursements without having to tap into other savings or selling off the actual stocks.
1) Why Dividends Matter
A stock's capital-gains potential is influenced significantly by what the market does in a given year. Stocks can buck a downward market, but most don't. On the other hand, dividends are usually paid whether the broad market is up or down.
By way of example, Procter & Gamble, the global leader in superior consumer products just announced a dividend increase for the 67th year in a row and dividends for the 133rd year in a row dating all the way back to 1890! The incredible thing about P&G’s track record is they have been incredibly steady in giving dividends even in years when the economy has been poor, and their stock price may not have risen or increased in value.
2) How Do Dividends Affect a Stock's Share Price?
There is some debate about how and why dividends impact the share price of a stock. As an example, a company that is trading at $100 per share declares a $3 dividend on the announcement date. As the news becomes absorbed by investors and the public, the share price may increase by $3 to $5 per share and hit $65 because the stock is now much more valuable because of the dividend.
3) Payback on your initial investment
Dividends can provide not only income but may also accelerate the payback on investment. Think of payback as a safety-net approach to stock investing. Nobody knows for sure how a stock is going to perform over time, but calculating a payback period helps establish an expected baseline performance—or worst-case scenario—for getting your initial investment back.
Calculating a stock's payback based on dividend flow forces you to address the following question: If this stock never makes me any money in terms of price appreciation, how long would it take for the dividend payments to pay off my initial capital investment?
To understand the concept of payback, look at the following example. Let's say you buy 1,000 shares of a $200 stock. Your investment is $200,000 and the stock pays an annual dividend of $5.00 per share (that's a yield of 2.5%). Based on that dividend, you expect to receive $5,000 in dividends in the first year. If that dividend stream never changes, you will recoup your initial $200,000 investment in 40 years. But what if that dividend stream grew 5% per year? In year 2, the dividend would be $5.25, then in the 3rd year $5.51, etc. In theory, you would recoup your initial investment in about 20 years. In other words, increasing annual dividends also reduce the payback period significantly!
