Dividend Investing for the Layman
The most old school metric of investing that is often overlooked
Warren Buffett started buying shares in Coca-Cola in 1988, when he first purchased around 2 million shares at a price of $2.73 per share, translating to roughly $5 million worth of investment.
Fast forward to today, keeping the phenomenal stock price appreciation on the side, his yearly dividend from Coca-Cola amounts to $736 million.
Okay, I hope I've got your attention with this outlier example to give you a direction on where this blog post is headed.
It's surprising how few people speak about the impact that dividends can have on the journey of wealth creation in a stock.
I wrote this blog post to put my practical and professional knowledge into writing, explaining the simplicity of dividends by using a hypothetical example.
This piece is also a reminder to myself on the importance of dividends in the long-term investing journey. The writing of this piece also helped me to reinforce my own understanding of the concept of dividends in the investing journey.
It feels like in the modern day, not many people speak about the positive impact that investing in a dividend-paying company can have on your actual holdings in the long term.
Back in the day, in older times when technology was in a primal stage, the easiest way for a mere mortal investor to understand the profitability of a company was to see whether they were distributing dividends or not.
Many old-school investors even chose investments based on whether the company was paying out a dividend or not back in the day.
Two variables dictate the returns in a stock price:
Price Appreciation
Dividends
Point 2 is often missed by investors looking at established companies as they feel it is not a significant part of a stock’s returns.
(It is assumed that price appreciation is kept in mind as the sole focus, but the point is to not neglect the aspect of dividends entirely)
Dividends are generally paid out of a company’s profits to reward the shareholders.
The more advanced analysis would signal the payment of dividends possibly as a sign that the company is paying out dividends because it has fewer avenues to deploy that money for growth, and typically 'more mature' companies pay out dividends.
But this is not a post on the analysis of why a company is paying dividends or not; it is a basic reminder for the layman of how accumulated dividends for the investor can reap rich rewards over the long term.
I highlighted these points in bold to clarify where the blog post is headed and to prevent other ideas from forming in the reader’s mind as they progress.
Before I progress with the hypothetical example, it’s important to simplify some basic definitions so that the layman may not be overwhelmed with certain words.
What is a Dividend?
A dividend is a distribution of a portion of a company's profits to its shareholders, typically in the form of cash
What is a Dividend Payout Ratio?
The Dividend Payout Ratio is a financial metric that measures the proportion of earnings a company pays out to its shareholders in the form of dividends.
For example, a company pays out 20% of its profits as a dividend.
What is a Dividend Yield?
The dividend yield is a financial ratio that indicates the annual dividend income as a percentage of the current market price of a stock. It helps investors assess the return they're receiving from dividends relative to the price they paid for the stock.
Example: The dividend per share divided by the market price of the share determines the dividend yield.
What is the Face Value of a Share?
The face value of a share, also known as par value, is the nominal value assigned to a share by the issuing company. It represents the minimum value of the share as specified in the company's corporate documents and has no direct relation to the market value of the share.
Face value differs from the market value of the stock.
This basic understanding of face value is important as dividend per share for the investor is paid out using the following formula:
Dividend Payout Ratio% x Face Value of the Share= Dividend per share
What is the Record Date?
The company announces the dividend along with the declaration date when it decides to pay a dividend. This is usually done through a press release or a regulatory filing.
What is Ex-Dividend per Share?
The ex-dividend price per share is the price at which a stock begins trading on the day following the ex-dividend date, which is typically lower by the amount of the dividend per share. This adjustment reflects the fact that buyers of the stock after the ex-dividend date are not entitled to the upcoming dividend payment.
When a share trades ex-dividend, it means the buyer won't receive the upcoming dividend payment. For instance, if a company declares a Rs 70 dividend payable on May 1st and the ex-dividend date is April 15th, anyone purchasing the stock on or after April 15th won't receive the dividend. The stock price typically adjusts downward on the ex-dividend date to reflect the value of the dividend being paid out.
What is the Payment Date?
The date on which the company actually pays out the dividend.
Companies that pay dividends, typically pay out a dividend every quarter of the year.
What is a Bonus Share?
Bonus shares are not directly relevant to dividends, but they add to the value of dividends in the long-term investing process. They are additional shares given to existing shareholders at no cost, enhancing their overall holding in the company without requiring additional investment.
A bonus share issued by a company is an additional share given to existing shareholders at no cost, based on the number of shares they already own. It's a way for the company to distribute its profits or reserves to shareholders without paying cash dividends
Example:
Say you bought 100 shares of a company at a market price of Rs 50. The company declared a 20% dividend payout of the total profits it earned that year; the dividend per share is calculated on the face value of Rs 10 per share. This means 20% of Rs 10 is Rs 2 per share.
Your total dividend is Rs 2 per share, and since you have 100 shares, you will receive a cash inflow of 100 x 2 = Rs 200 on the payment date, which you can reinvest to buy more shares of the company.
The share now trades at an ex-dividend price of Rs 50 - Rs 2 = Rs 48 upon the announcement of the ex-dividend date by the company.
At Rs 48, considering that I have Rs 200 cash in hand after the payment of the dividend, then I can buy around 4 more shares of the company, taking my holding up in the company to 104 shares.
The next year, the company declared a 25% dividend payout of the total profits; the dividend per share is calculated on the face value of Rs 10 per share. This means 25% of Rs 10 = Rs 2.5 per share.
Your total dividend is Rs 2.5 per share, and since you have 104 shares, you will receive a cash inflow of 104 x 2.5 = Rs 260 on the payment date, which you can reinvest to buy more shares of the company.
The share price has gone up to Rs 60 that year and is trading at an ex-dividend price of Rs 60 - Rs 2.5 = Rs 57.5 per share.
Now you can buy approximately 4 more shares of the company with the Rs 260 cash in hand that you have at the ex-dividend price of Rs 57.5, thus taking your total holding up to 108 shares in the company.
In the third year, the company issued bonus shares of 1 share for every 5 shares held as a reward to the shareholders from the company’s profit/reserves.
Now, for every 108 shares I hold in the company, I receive approximately 21 more shares because of this bonus issue, taking my holding up to 129 shares in the company. (108/5 = 21 shares)
In just three years, the number of shares I hold has increased from 100 shares to 129 shares, simply by staying invested and reinvesting the dividends I earned back into the stock, without spending an additional penny from my pocket.
The company declared another dividend this year, keeping the dividend payout ratio at 25%. Again, the dividend per share is calculated as 25% of the face value of Rs 10, which equals Rs 2.5 per share.
The total cash inflow for the investor this year will be Rs 2.5 per share x 129 shares = Rs 322 on the payment date.
Meanwhile, the share price in these three years has also gone up from Rs 50 to Rs 90.
The share price has gone up to Rs 90 in the third year and is trading at an ex-dividend price of Rs 90 - Rs 2.5 = Rs 87.5 per share.
At an ex-dividend price of Rs 87.5 and cash in hand of Rs 322 upon receiving the dividend, the investor can buy approximately 3 more shares of the company without investing an additional penny from their pocket.
This takes the total shareholding of the investor to 132 shares, an increase of 32% in the total holding of the investor’s shares without paying an additional penny through a mix of the bonus issue and the reinvesting of dividends.
Even if the stock price had not appreciated at all over these three years, dividends could have helped to increase the value of your investment regardless, since the number of shares you hold goes up when you reinvest those dividends.
Eventually, you have to decide whether to hold or sell the stock based on the fundamentals of the business and the valuations, but these dividends have partially helped your cause over this period.
This virtuous cycle of investing in a high-quality dividend-paying company over the long term can reap good benefits for the investor.
The point of this simple example is that over the very long term, these dividends could even become a regular source of income for an investor from the stock, assuming all goes well with the company. I personally know many investors who earn handsome amounts of money from dividends because they invested in good quality dividend-paying companies over various market cycles over decades and are now reaping the rewards.
In the hunt for appreciating stocks over the long term, we tend to miss out on the role that dividends can play.
For those who invest in mutual funds, the fund reinvests these dividends earned back into the fund, which adds to the journey of compounding over the long term.
Other discretionary funds also allow the fund manager to reinvest dividends back into the investor’s portfolio. This helps investors who are not proactive in doing so.
Conclusion
This is a very simplistic example of the role a dividend-paying company plays in the power of compounding, but it is not the only factor to consider.
Refreshing this core concept in my mind by putting it into words has been enjoyable.
Price appreciation plays a more important role, yet it's surprising how the modern-day investor tends to overlook this small but powerful metric that can make a big difference to the price of a stock over the long term.
In fact, any new age or young professional I speak with often doesn't even have this word in their dictionary, so this reminder is probably for them too.