FP Article 10

Why Bother With Dividend Investing?

by Rajen Devadason

Do you know the only thing that gives me pleasure? It's to see my dividends coming in.

John D. Rockefeller 

In the simplest of terms, a dividend is nothing more - nor less! - than a payment in cash (or less commonly in the form of stock), made from the earnings of a company to reward its shareholders.

In our capitalist society, the easiest way for anyone to partake of the rich fruits of capitalism is to become a partial owner of a solid business that generates profits and rewards its owners on a regular basis.

Each time we invest in a stock, we hope for one of two things to happen:

1. The price will go up - this is known as capital appreciation; and

2. The investment will generate a healthy stream of cash - this is obviously the regular dividend stream I believe each of us should aim to put in place for ourselves.

DIVIDEND BASICS

Let's say there's a listed company called Cash Bulge Ltd, which made 40 cents a share in the last financial year. For the sake of this simple example, let's say it made $40 million in net profit during that period and that it has a share base of 100 million shares.

You see where the '40 cents a share' I mentioned came from.

Its board of directors may decide that of that $40 million, it would like to reward its shareholders a total of $10 million.

Shareholders will thus receive a dividend cheque that is directly linked to the number of shares they own. If a person has only one share, he would receive $0.10 [=($10 million/$100 million) x 1]. Another investor with one million shares would receive 1 million x $0.10 = $100,000.

The company gives out $10 million in total to all its shareholders, and retains $30 million for its ongoing business expansion plans.

For most long-term investors, the cumulative effect of receiving dividends once a year or once in six months or even more often is a fantastic benefit of holding common stocks.

DIVIDEND COVER

But as much as these investors like receiving their dividend cheques, they realise the company must continue to keep enough of its profits to sustain growth. That's why investors are generally leery of companies that pay out too much of their net profit.

How much is 'too much'? That question is best answered by working out what's known as the dividend cover. This is investment lingo for a simple idea:

The number of times a company's earnings for the year can cover its total payment for that year. In our case, the company has a gross dividend cover of $0.40 divided by $0.10 = 4 times.

The inverse of the calculated dividend cover is called the payout ratio. In this case, Cash Bulge Ltd has a gross payout ratio of 25%. The reason I've added the word 'gross' in this paragraph and the preceding one is to indicate the quantities being referred to ('gross dividend cover' and 'gross payout ratio') are shown before the company strips out the corporate tax charge that usually needs to be paid to the government on behalf of each shareholder.

DIVIDEND PER SHARE

That's probably more detail that you want to have right now. What you should be very conscious of, however, is the DPS or dividend per share quantity.

Working out the DPS is easy. Simply add up all dividends paid out over a one-year period and divide that amount by the number of shares the company has issued during the financial year.

For companies that don't change the number of shares through bonus issues, rights issues and subsequent public offerings or via a share buyback scheme, there is no further complication. For those companies that do carry out corporate finance exercises that change the number of shares during various points of the year, then the weighted number of common shares for the year must be used when working out the DPS.

DIVIDEND REINVESTMENT PLAN (DRIP)

Do not confuse a DPS and a DRIP. A DRIP is not something that's available in all countries. In nations like the US, where DRIPs are available, investors gain access to easy forms of  reinvestment.

In these instances, those companies with a DRIP programme pay out NOT cash dividends but rather stock dividends! Each time a stock dividend is declared, therefore, investors gain more shares! 

DIVIDEND YIELD

I hope you are now sufficiently inspired to begin the process of buying long-term stock holdings with a view to building up a robustly gushing stream of dividend income.

If so, you must keep track of the dividend yield of each of your personal stock holdings.

You calculate this quantity by first taking the total dividend paid out in the last year and dividing it by the stock's current price.

CONCLUSION

It's likely that within your local stock market are many dividend-paying stocks that warrant closer inspection. I suggest you print out this article (or at least bookmark it) so that you'll have it handy to reread the next time you choose to research possible additions to the dividend-paying portion of your overall portfolio.

Happy investing!

© Rajen Devadason