Stocks
Young Fools
March 25, 1998

Dividends

When Companies Pay You: Dividends

A cool thing about stocks is dividends. When a company regularly makes a good profit every quarter, it often shares that wealth with its shareholders. It pays them all a "dividend." The dividend is usually the same amount each quarter, and you can find out how much of a dividend a company pays (if it pays one) just by looking it up in your daily newspaper's business section.

Let's take an example. Chrysler is a huge automobile manufacturer. As of March 6, 1998, it pays its shareholders a dividend of 40� each quarter, which amounts to $1.60 each year. So if you own shares in Chrysler (Ticker symbol "C" on the New York Stock Exchange), even if the stock's price doesn't go up much, you still get the dividend. Not a bad deal, eh?

$1.60 might not seem like much, but if you own 10 shares, it comes to $16 per year. For 100 shares, it's $160. See how it's not small change anymore?

Who Doesn't Pay Dividends?

Not all companies pay dividends, though. Older, bigger companies often do, while young, growing companies don't. Can you guess why? Well, young, growing companies need all the money they can get their hands on. They want to build new factories or equipment, hire more workers, buy more supplies, advertise more, and so on. As their new products or services become popular, demand for them will grow. These companies have to try and meet that demand, to make as much as they can. Whatever profit they make goes toward paying for things that will help them grow. And as they grow, their stock price will often grow with them.

Meanwhile, older, bigger companies just aren't growing that fast. Should a gigantic company like Exxon use its profits to grow faster? Well, it really can't grow too much faster. People are not going to buy more gasoline tomorrow than they did today. They only buy what they need. If Exxon doubled the number of gas stations in America, would it double its profits? No. Boeing might be able to sell a few more airplanes each year, but it probably doesn't need money to build many more factories. Similarly, Chrysler will be trying to grow, but it just can't grow too fast. (Imagine an elephant trying to outrun a lion.) So these companies make up for their slower growth by paying their shareholders dividends.

Does this mean you should only invest in companies that do or don't pay a dividend? Not at all. Many terrific companies pay dividends (Coca-Cola) and many terrific companies don't (Microsoft). You probably shouldn't make a stock purchase based on whether or not the company pays dividends. But you do want to understand what dividends are. If a company you're thinking of buying shares in does pay one, you need to understand what that means.

Some Easy Math: The Dividend Yield

A very useful thing to do with a dividend is figure out the "dividend yield." A dividend yield is something like the interest rate the bank pays you -- it tells you what percent the company will pay you, based on the current price of the stock. First, you need to know how much the company pays in dividends each year. Then you need to know what price the stock is trading at now. It's time for an example. Let's say that the El Nino Umbrella Company is an old, respected company that sells... well, yeah... umbrellas. Its sales are steady and it isn't growing much. It pays its shareholders $1.00 per quarter, or $4.00 per year. A share of El Nino is currently trading around $80.

To find the dividend yield, you divide the total dividends for the year ($4.00 in this example) by the stock price ($80). $4.00 divided by $80 is 0.05. That is the same as 5%. That means that if you buy a share (or a thousand shares) of El Nino now, at $80, you'll earn 5% each year, even if the price doesn't change. That's better than many bank accounts! Is it risk-free? Not completely. If the El Nino Umbrella Company falls on hard times, it might reduce its dividend, maybe to $3.00 per year. Maybe it will just stop paying a dividend altogether. But companies don't do that too often -- they know it will make their shareholders very unhappy.

There's an upside, too. If a company is doing well, it might increase its dividend now and then. And its share price might also go up. That means that if the share price rises 15% in a year, you'll get the 5% dividend on top of it -- a 20% return!

One more thing to keep in mind is that while the amount of a company's dividend doesn't change too often, the dividend yield does change all the time. Why? Because it's directly tied to the share price, which also changes all the time. As a stock price goes up, its dividend yield goes down, and vice versa. So if the price of El Nino drops to $75, the dividend yield will rise to 5.3%.

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