The power of dividends

A dividend is a percentage of the profit the company you have invested in has earned over the last financial quarter, six months, or year. When and how often a company pays a dividend depends on their dividend policy. Some companies only pay once a year, while others pay every 3 or 6 months. In order to find out, all you need to do is go on a company’s investor relations site that is accessible for free and to everyone through the corporate website.

It is not uncommon for a company to offer 4% or more in annual dividends. That is, if you invested €1000, your annual return would be €40 from dividends.

Some companies, however, do not pay any dividend. Some because they are legally not allowed to, others because they choose not to. The former category has included a number of the banks that were bailed out during the Great Recession. The other category includes, until recently, companies such as Apple. Steve Jobs was convinced that it would be better to keep large cash reserves and reinvest 100% of the profits. He was opposed to returning any share of the profits to his Apple’s shareholders. Thus, one of the most profitable companies in the world paid 0% dividend.

For any dividend investor, that is investors who choose companies with a high dividend instead of companies that might return steep share price rises, this would not be the type of investment they seek.

Whatever investment strategy you choose, check the corporate website’s investor relations section to see whether you feel content with their dividend policy.

Beware; those costs may destroy your dividends

As you saw earlier, your investment success also depends on how you manage your trading costs. On top of that, the more you have invested the more money you’ll get for your buck. If you choose your investment wisely, your investment should produce good dividends. The lower your trading fees and the higher your investment, the greater the percentage you earn through dividends. Take the following example: your shares are not gaining in value, but are paying a 5% dividend per year:

*(Buying Cost in €) / (Investment Amount)

** Dividend Net Return (€) = (5% Dividend Yield) – (Buying cost in €)

*** Dividend Net Return (%) = (Dividend Net Return (€)) / (Investment Amount)

You can see from the column in gray that in order to achieve a positive dividend return, it is necessary to invest a minimum of €500; and that is not considering the trading costs if you were to sell your shares again, as you stop earning dividends at this point. The more you invest, the less of your dividend return is eaten up by the buying cost, let alone the total trading costs (buying + selling).

Dividend versus share price gains

The beauty of investing in shares, particularly when compared to savings accounts, is that they offer two types of potential returns: 1) dividends and 2) share price gains.

A high school teacher recently told me that his students and many of his colleagues understood the concept of dividends as follows:

A 4% dividend is equal to a 4% increase in share price. This is, however, not the case. The two are indeed interrelated. However, not as the above logic would suggest. In fact, the share price of a company might move depending on dividend prospects. If a company announces a future increase of the dividend, the shares are also likely to increase in value, as the increase in share price may, for instance, reflect higher profits. A share price increase in such case may thus stem from an investor’s desire to partake in the higher returns.

Another reason for a higher dividend may be a policy change, where management decides to pay out a greater percentage of the profits. For instance, a company that enjoys the same profits in two consecutive years, but changes its payout ratio from 40-50% will yield a 10% greater dividend for shareholders without any actual changes in profit.

But that does not mean that a 4% dividend increase translates into a 4% increase in share price. Depending on the cause for the dividend changes, the result for the share price will differ accordingly. The beauty of shares is that you can potentially profit from a share price gain and a regular dividend.

However, sometimes the relationship might even be inverted with a higher dividend reflecting lower profit projections. One such company was Deutsche Telekom, which, for a prolonged period of time offered a high dividend despite a subpar organizational performance. The reason for the high dividend was a stagnate share price. By offering a higher-than-market dividend, companies hope to attract investors and a subsequently higher share price, as with an increasing influx of investment, the share price has the potential to also move upwards.

On the other hand, companies might choose to return 50%, 60%, or 70% of the profits to their shareholders. Take, for instance, Intercontinental Hotels. The owner of hotels such as Intercontinental and Holiday Inn, paid out $ 750 million from the sale of some of their hotels to shareholders in form of a special dividend in 2014; that is, a dividend paid on top of regular dividends. Investors, who have held Intercontinental shares, have seen steady dividends over the last few years, while their share price has simultaneously gained. Shareholders thus profited threefold: steady dividend returns, a special dividend, and an increase in their portfolio’s value.

Share price and dividend changes, while not synchronous, may balance each other out when one declines while the other increases. But dividends and the actual share may also add to your wealth twofold when price increases are accompanied by dividend payments.

Where to go to find information on shares and dividends

You can either find information on a company’s website in the investor relations section, the notes from their AGM, or go to one of the many sites that offer the most relevant information free of charge. Some of the websites providing such information are Bloomberg, Yahoo, Google, and your chosen trading platform, where you can usually research listed companies. Type whatever company you are looking for into their search function and their financial history, news, information, and future estimates will pop up.

Return to Part 2 to learn about keeping trading costs down