Question On Dividend Payouts

[jpluncford21]

Can someone please explain dividends to me. I have a broad understanding of what a dividend is, but no idea about the terminology (i.e. dividend rate, yield, etc.). I've read the guest posting by Dividend Mantra, and poked around for some definitions, but minus the finance or business background, it's all a little confusing. Thanks in advance

[JJ]

Basically dividend yield = dividend / share price. So a 5c dividend per year on a share that costs $1 is a 5% yield.

If you watch this thread for a day or two I'll post a more comprehensive reply. It is no good knowing what the div yield is if you don't know why it is important and what other numbers you need to look at to ensure it remains sustainable. Briefly, though, if a company has to keep borrowing to maintain its annual dividend it will go busy before too long. If it pays so much dividend that it has nothing left to invest in growth, it will stagnate.

[AdrianM]

You may find this a good place to start

http://www.investopedia.com/terms/d/?page=6#axzz2BakEsAFW

Its investopieda's dictionary, I have preloaded it for you at dividends.

[fiveoh]

Can someone please explain dividends to me. I have a broad understanding of what a dividend is, but no idea about the terminology (i.e. dividend rate, yield, etc.). I've read the guest posting by Dividend Mantra, and poked around for some definitions, but minus the finance or business background, it's all a little confusing. Thanks in advance

The dividend rate is the amount paid per year in dividends.  I.e. a .25 a quarter dividend would be a $1 rate.  JJ already explained yield.  Are you planning on investing in dividend stocks?  What prompted the questions?  As JJ said there are a lot of other things to check when looking at dividends.  check out the dividends and income section of seeking alpha for some good articles. 

http://seekingalpha.com/article/977141-retirees-it-s-time-to-learn-more-about-dividend-growth-investing

is a recent one that explains the basics of dividend growth investing if you are interested. 

[jpluncford21]

@JJ: I'll be checking in a few times to read responses, so feel free to post whatever information you want.

I've looked over some definitions from Investopia, but was still just a little confused. Again, I get lost in the finance jargon sometimes so even definitions seem to take a little research. I find sometimes that I learn best from discussion with people, even if it's online.

I am interested in dividend paying stocks as another source of supplimental income. I am still new to investing and am still learning how to value stocks, where to invest and in what ratios. Passive income is obviously going to play a big role in becoming  FI; and although I don't necessarily agree with 100% income investing (again...based on a small amount of investing knowledge), I see the need for a steady stream of supplimental pay. I read over the "Dividend Aristocrats" posting yesterday and that was a good starting point for stocks to look into. Just interested in an intellegently diversified portfolio I guess.

[fiveoh]

@JJ: I'll be checking in a few times to read responses, so feel free to post whatever information you want.

I've looked over some definitions from Investopia, but was still just a little confused. Again, I get lost in the finance jargon sometimes so even definitions seem to take a little research. I find sometimes that I learn best from discussion with people, even if it's online.

I am interested in dividend paying stocks as another source of supplimental income. I am still new to investing and am still learning how to value stocks, where to invest and in what ratios. Passive income is obviously going to play a big role in becoming  FI; and although I don't necessarily agree with 100% income investing (again...based on a small amount of investing knowledge), I see the need for a steady stream of supplimental pay. I read over the "Dividend Aristocrats" posting yesterday and that was a good starting point for stocks to look into. Just interested in an intellegently diversified portfolio I guess.

Sounds like a good approach.  Just be careful not to focus too much on the dividend.  Just because a stock is a dividend aristocrat doesnt mean its a good buy at this time. 

[jpluncford21]

Basically dividend yield = dividend / share price. So a 5c dividend per year on a share that costs $1 is a 5% yield.

If you watch this thread for a day or two I'll post a more comprehensive reply. It is no good knowing what the div yield is if you don't know why it is important and what other numbers you need to look at to ensure it remains sustainable. Briefly, though, if a company has to keep borrowing to maintain its annual dividend it will go busy before too long. If it pays so much dividend that it has nothing left to invest in growth, it will stagnate.

Ok so by the explination above using http://investing.money.msn.com/investments/stock-price/?symbol=MCD&icid=mktupdnews as an example. If McDonalds has a yield of 3.55, does that mean that they are paying out 3.55c/every share? And since their dividend rate is 3.08, would an investor recieve 3.08c/share every year?

[fiveoh]

Basically dividend yield = dividend / share price. So a 5c dividend per year on a share that costs $1 is a 5% yield.

If you watch this thread for a day or two I'll post a more comprehensive reply. It is no good knowing what the div yield is if you don't know why it is important and what other numbers you need to look at to ensure it remains sustainable. Briefly, though, if a company has to keep borrowing to maintain its annual dividend it will go busy before too long. If it pays so much dividend that it has nothing left to invest in growth, it will stagnate.

Ok so by the explination above using http://investing.money.msn.com/investments/stock-price/?symbol=MCD&icid=mktupdnews as an example. If McDonalds has a yield of 3.55, does that mean that they are paying out 3.55c/every share? And since their dividend rate is 3.08, would an investor recieve 3.08c/share every year?

You are correct on the rate, but not on the yield.  You get the yield by taking the rate($3.08 in this case) and dividing by the stock price.  So for MCD it is 3.08/85.47= 3.60%(note the yield on msn is not up to date by the minute, I think they calculate it on the more recent close).  So with a 3.60% yield for every $100 of MCD stock you own you will get $3.60. 

When the stock drops in price the yield will rise... i.e. if MCD goes to 80 it will be 3.08/80 = 3.85%.   The reason for this, you are still getting the same $3.08(the rate) but on a lower stock price. 

Let me know if this makes sense. 

[skyrefuge]

I am interested in dividend paying stocks as another source of supplimental income. I am still new to investing and am still learning how to value stocks, where to invest and in what ratios. Passive income is obviously going to play a big role in becoming  FI;

It's impossible to say this without sounding like a dick, but please know that my goal is to help.

If you don't have the interest/ability to search out an explanation of dividends on your own, then you also have no business picking individual stocks.  Just buy index funds.  They include dividend-paying stocks within them, but you don't need to know anything about individual company dividend policies.

And don't worry, almost no one has any business picking individual stocks, even people who think themselves to be investing super-wizards and spend hours each day researching financial minutia.  I don't do it, MMM doesn't do it (or at least not without regret), and I think most of this community doesn't do it.  While it's certainly good to understand dividends, you don't need any particular focus on them in order to get passive income from equity investments.

[jpluncford21]

I am interested in dividend paying stocks as another source of supplimental income. I am still new to investing and am still learning how to value stocks, where to invest and in what ratios. Passive income is obviously going to play a big role in becoming  FI;

It's impossible to say this without sounding like a dick, but please know that my goal is to help.

If you don't have the interest/ability to search out an explanation of dividends on your own, then you also have no business picking individual stocks.  Just buy index funds.  They include dividend-paying stocks within them, but you don't need to know anything about individual company dividend policies.

And don't worry, almost no one has any business picking individual stocks, even people who think themselves to be investing super-wizards and spend hours each day researching financial minutia.  I don't do it, MMM doesn't do it (or at least not without regret), and I think most of this community doesn't do it.  While it's certainly good to understand dividends, you don't need any particular focus on them in order to get passive income from equity investments.

No offense taken. However, in my defense; As I said above, I have looked over definitions from investopia, cross referenced financial language, etc. In the interest of time management and to gain a little clarity, it is more efficient to do some research here by asking a question in an easy to understand way. I knew coming here that being able to interact and clarify Q&As with peers would lead to a better and more in depth understanding of my question than spending time searching through different financial sites and not being able to interact with the author. Interest/Ability: Using multiple sources to gain an understanding of a particular part of investing that had been a bit confusing to me and not settling on, "well that makes no damn sense so I give up". Also, providing someone who might also have the same question with a quick source for an answer that may be a bit easier to understand.

Fiveoh: Thanks for the reply. That's completely clear now. I get more and more interested the more I learn about investing and finance. This should definitely be emphasized more in general HS and college curriculum.

[JJ]

Ok, here's a bit more of an explanation.  Hope it helps...

Suppose your dad has a business running a small grocery store.  The store takes in $500K per year, and rent, insurance and the cost of the goods sold comes to a total of $400K.

That leaves a gross profit of $500-400 = $100K.  This would be called "EBITDA" - earnings before interest, tax, depreciation and amortisation.
The shop has a load of fittings and other things needed to run the business, plus a delivery van.  These need replacing from time to time because they get old and wear out.  An additional non-cash expense encapsulates the rate at which these things wear out.  This is called depreciation.  In theory it represents the money you should set aside each year to replace things you need to run the business.  A building will typically wear out over 40 years so if you have a building which cost $1M to build you will charge depreciation at 2.5% = $25,000.  After 40 years you should have set aside $1M to replace the building.  Of course, by the time you get there it now costs $5M to replace a building, but that's another story.

Anyway, back to the store earnings.  We have $100K of gross earnings (EBITDA).  We deduct another $20K of depreciation to cover things wearing out.  This leaves $80K of EBIT (earnings before interest and tax).  In case you are wondering where the amortisation went, it's basically the same as depreciation, but for non-tangible assets (i.e. not buildings, computers, vehicles etc, but things like trademarks, valuation of brands - I'm sure an accountant will ping me on this).

So we have $80K of EBIT.  Because we're good little mustachians we don't have any debt so we aren't paying interest on loans.  However, we do pay tax - let's say at 25% to keep the numbers easy.  This leaves $80K - ($80K * 25%) = $60K.

So our net earnings is $60K.

We have three choices what to do with this.  We can pay it to the business owners - this is the dividend.  In this case the owner is your dad, so he pockets a $60K dividend.  We can retain it in the business as retained earnings sitting in the bank not doing much or we can retain it in the business to invest in growth.  We can, of course, do a mix of all three.

For the sake of this example, let's say we pay $30K to the owner as a dividend and keep $30K to buy a fancy new espresso machine and build a small deck with some nice tables and umbrellas at the front of the store.  The "dividend payout ratio" is 50% because half of the earnings for the year are paid to the owner.

Let's also say, for the sake of the example, that your uncle actually owns 30% of the business and there were 100 shares originally created.  So your father owns 70 shares and your uncle owns 30 shares.  The "dividend rate" is $30k/100 = $300 per share.

Now the shares, when the business was first created, were issued at $1 each.  It was a long time ago.  The dividend yield at the original share price is $300 / $1 = 30,000% !!! outrageous.  However, your uncle wants out.  He shows your brother-in-law how great the dividend is and sells the shares to him for 10x the dividend rate, so $3000 per share.  The new valuation per share (i.e. what the "market" will pay for them) is now $3000 rather than the original $1 that they were issued at.  This makes the current "dividend yield" $300 / $3000 = 10%.

You uncle, meanwhile, has made a handsome capital gain of $3000 - $1 = $2999 per share.  And Uncle Sam has made a handsome sum of tax on this capital gain.

[JJ]

Part II:
Now, back to the $30K that your dad spent on the espresso machine.  Although he is mustachian, most of the neighbourhood is not so he sells 200 coffees a day at a $2/cup profit margin.  This adds $400/day = $100K per year (give or take) added to EBITDA.  Let's say this ends up being $60K additional net earnings.

Net earnings has grown from $60K to $120K - 100% growth.
Furthermore, the return on the capital spent ($30K) is 200% - Totally awesome.  If you could buy shares in a growth business like this you are home and hosed, but very very hard to find at a decent scale and publicly traded.  This is what offices full of analysts spend their days trying to find.

Now there are a few comments above about getting yourself into trouble through not understanding how to pull apart the finances of a business and how that can end in trouble.  Here are a couple of scenarios with this example business to illustrate what can go wrong:
1. Instead of buying an espresso machine your dad gets the business to spend $30K on a fancy new car.  This adds nothing to the revenue of the business.  $30K down the drain which could have been paid to shareholders.  You see this every day with corporations.  Big fancy new offices, sponsoring yacht races etc.  Warren Buffet talks about corporate waste in the Berkshire Hathaway annual reports.  You could get a lot worse education than reading through those.

2. You dad misreads the market and it turns out he's in Vegas where, apparently, no-one knows what a decent espresso tastes like.  Especially at the convention centre.  Rather than selling 100 a day he only sells 5 on average to a few pretentious yuppies sneaking across the state border in their Foresters for a session at the tables.  $30K invested yields $2500.  Not bad, but not really worth getting out of bed for.

3. Your dad doesn't invest in staff training so the barista doesn't know how to tamp the grounds properly, uses stale coffee etc.  Consequently a bad product is shipped to the customer.  Word gets around.  Same effect - 5 coffees per day sold to folks with no taste buds.

4. Your dad (with a vote from your mum - the other board member) awards himself a $30K bonus for great performance.  Together with the $30K spent on the espresso machine there is nothing left as a dividend to the other shareholders.  Brother-in-law is not happy.  This happens very frequently too - the executive management, in cahoots with the board, create remuneration plans which strip the profits before they are even reported.

5. The majority owners of the business decide they want a fat dividend.  They pull the whole $60K profit out leaving nothing to invest in growth.  The $100K per year of additional earnings possible through the espresso machine is lost for the sake of an extra $30K of dividend distributed once.  This typically happens when major institutional investors demand a certain dividend rate.  Again, you can read Warren Buffet's thoughts on this.  He has consistently reinvested internally generated profits and over 40 years made staggering buckets of cash for Berkshire Hathaway.

6. Possibly the worst crime of all.  The business made $60K profit, the owners demand a $100K dividend.  The business borrows money or raises additional capital through creating and selling more shares to pay for the shortfall between profits and dividend payout.  Although this is blatant stupidity on a huge scale it does happen.  Not only has the business not reinvested into growth, it has taken on debt and the ongoing servicing costs which will eat away at future profits and eventually cripple the business.

7. $20K of the profit is booked because Mrs Meggs comes in and orders 16 tonnes of cabbages for the next 12 months.  She will pay after they are delivered.  That $20K is paid out as dividend because it is reportable as profit even though the cash hasn't hit the bank yet.  As a result the bank account is stripped clean and your dad can't pay his suppliers.  The company is now insolvent due to timing of when profit is reported and when cash is received.  This is a silly example, but things like this happen all the time.  Services companies, particularly ones which are growing aggressively, often have a big lag between work in progress being recognised as revenue and when the cash arrives.  They can't delay their expenditure because it is payroll and high paid consultants tend to quit if they don't get paid on time.  Net result is a cash-flow hole which leads to big trouble.  Just ask anyone who hasn't kept up with their mortgage payments - same story for business.

That is an example of some of the things which can go bad in a business.  There are many, many more.  You can often see it for publicly traded companies.  For example, you can see on MMM forum the love for Hondas etc - nice panel fit, last for ever, nice to drive etc, etc.  You don't hear much love for Ford or GMC.  Guess what, that's the same story as the untrained barista churning out crappy espresso coffee.  They haven't kept up with what world-class looks like, ship an inferior product at higher cost and sales die off resulting in huge financial losses, resulting job losses and a very sad and sorry picture in Detroit.  You could see it years out based on what people are talking about on the street so you would want to steer clear of those businesses.

Also be aware of people's motivations which can drive how they report data to the public.  Although the financial reporting rules for public companies are quite stringent (following Enron etc) there are always plenty of way to manipulate raw data into something which looks a whole lot better.  This behaviour is often driven by short term incentive plans for senior management.  The manipulated data can hide the true state of affairs.

If you are going to invest in individual shares you need to learn to read balance sheets, profit and loss statements, cash flow statements and all the boring notes which clarify how the numbers were derived.  You can see most of these problems from the financial statements.  However, it is hard to judge long term viability and growth potential from the financial statements - for that you need a lot of qualitative data.  Phil Fisher had a lot to say about that: http://en.wikipedia.org/wiki/Philip_Arthur_Fisher.  If you are seriously going to attempt share-picking you should get your hands on his books and read them carefully.

For me, personally, it is less of a headache to start your own business than invest into just one or two publicly traded ones.  At least you have an idea what the management is up to. ;).  And by the way, if you do run your own business for a bit you will start to read company annual reports in a totally different way.

Hope that helps...

[arebelspy]

That was a fun story JJ, well written.  Way to go.

[skyrefuge]

No offense taken. However, in my defense; As I said above, I have looked over definitions from investopia, cross referenced financial language, etc. In the interest of time management and to gain a little clarity, it is more efficient to do some research here by asking a question in an easy to understand way. I knew coming here that being able to interact and clarify Q&As with peers would lead to a better and more in depth understanding of my question than spending time searching through different financial sites and not being able to interact with the author.

Oh, yeah, totally no defense needed for asking questions!  Heck, without your question, we wouldn't have gotten that awesome and comprehensive should-be-a-blog-entry writeup from JJ.  The key point I was trying to make was "almost no one has the ability to succeed at being stock-picker", just like "almost no one has the ability to be an Olympic figure skater".  There are a million indications that can be used to disqualify someone from those rare groups, like I might say that a 25-year-old asking how to skate backwards should probably not set her sights on becoming an Olympic figure-skater.  But it's still a great and fun and useful thing to learn, so of course she should still ask about it.  You might not even have been interested in becoming a stock-picker (or Olympic figure skater!), but a lot of investing novices still seem to think that's a good route for them, so I like to nip such ideas in the bud, especially (as you say) for others who might come along and read this.