In our last post we talked about the ABC Company, a small fashion clothing store that had $500,000 in profit for the quarter (three months).
And we said there were a number of things they could do with that profit. In our last example, they divided the entire $500,000 profit among the 10,000 shares outstanding and paid all of the profit out to the owners of those 10,000 shares.
In the real world they would probably do something a bit different.
For example, they probably would not pay out the entire $500,000. They would keep some of it in their bank account in case they needed it. We’ll call that the “Rainy Day” reason.
Or they might keep all of the $500,000 in the company checking account and not pay a dividend at all. That’s still money in the bank for you because you are a business owner, so some of that money is yours.
Or they might save some of it because they want to open a new store in the future to make even more money. We’ll call that the “Business Expansion” reason.
Or they might use some of the money to buy back some of the shares of stock. If they did that, there would be fewer shares outstanding, so your shares would become more valuable. We’ll call that the “Share Buy-Back” reason.
So there are many things they can do with the $500,000 profit. But did you notice that all of them are good things for you? That makes sense, right – because you are an owner of the company, so the decisions should all be made to help you.
After all, as a shareholder, and owner of the company, it’s your money at risk. So you should get the reward.
Typically, companies will keep some of the profits and also pay some of the profits to the shareholders in dividends. That’s a pretty good compromise, really.
So let’s see what that might look like.
Let’s say the company keeps $450,000 of the profit this quarter and pays out the remaining $50,000 to the shareholders like you.
Since there are 10,000 shares outstanding, that means each share gets a $5 dividend. Since you own 10 shares, that’s a check to you for $50. And let’s say they do that every three months (i.e. every quarter) for this year.
That means you got $200 ($50 X 4 quarters).
Now banks are paying less than 1% interest on savings these days. In other words, you are getting less than a 1% return on your money if you just put it in a bank savings account.
So what kind of return are you getting on your dividend paying stocks in the ABC Company? Is it better or worse than if you just put your money in the bank?
Well, if the ABC Company stock price is $400 a share, and you own 10 shares, then you have $4000 invested in the company. And you are getting $200 in dividends paid to you each year.
So the return on your investment is the total $200 dividends you are receiving divided by your $4000 investment. $200 / $4000 = .05, or 5%.
That’s a nice dividend, and is more than five times the return you would get if you just put your $4000 in a bank savings account. And there are actually stocks out there today that pay that kind of dividend.
So you see, dividend paying stocks don’t just make your money work for you, they make it work much harder.
And that’s a good thing.