Pop quiz! And there’s just one question: “What Is a Dividend?” You probably know that it’s a bit of money paid out by a company to shareholders, but you may not know why the company does that, or what it might mean, for you and the company.
So let’s jump in, and start at the beginning. Imagine a company, such as Mops ‘n’ Brooms (ticker: SWABZ), with its compelling tag line: “Providing actionable domestic engineering solutions that leverage and optimize client excellence with a relentless focus on driving shareholder value going forward.” Now, assume that Mops ‘n’ Brooms is raking in a lot of cash every year. What will it do with that money? Well, it has lots of options. Here are some of the main ones: It could pay down debt, or build new factories, or hire more workers, or buy more advertising, or buy another company, or buy back some of its own shares, or invest it, or … pay a dividend. It may well decide to do a combination of some of those things, too.
Why does a company pay a dividend? Well, if it doesn’t see more effective ways to deploy its excess cash, then a dividend will make sense. This is why many companies, especially younger, smaller, or fast-growing ones, don’t pay dividends. They need all their excess cash to help them grow. Troubled companies often don’t pay dividends, either, as they may need their income to pay down steep debt. They may not even have any net income at the moment.
It’s not a bad sign if a company doesn’t offer a dividend. It can still reward shareholders by growing rapidly. But a dividend is a promising sign, suggesting that the company is relatively stable, with earnings predictable enough to permit it to commit to regular payouts.
The answer to the question “What is a dividend yield?” is a bit different from our “What is a dividend?” question. But they’re quite related. The dividend is the actual sum of money paid by the company per share — usually per quarter, and sometimes once or twice a year. But it’s hard to make sense of just that number. Two companies may both pay $1 per quarter, for example, but they’re not equally attractive (dividend-wise) if one costs you $20 per share, and the other costs $100.
Thus, the dividend yield. To get it, you divide the annual dividend amount by the current stock price. In our two examples, dividing $1 by $20 yields 0.05, or 5%. Dividing $1 by $100 yields 0.01, or 1%. So you’ll get five times as much dividend income if you buy into the $20 stock, because it has a juicier dividend yield.