Investing 101: Dividends

Let's talk about what to do with all that money that you've worked so hard on saving up. In this section titled Investing 101, I'll go over different terms and ideas that every investor should know.* Hopefully the information provided will help give you a general idea of how things work and build a foundation for you to go and further educate yourself. Welcome to class. Today's topic? Dividends.

There are four things a company can do with profits that they generate:

1. Reinvest it into the company to make even more money
2. Purchase other companies (mergers & acquisitions)
3. Buy back shares (therefore making outstanding shares more valuable)
4. Distribute the money to shareholders in the form of dividends

Companies can do a mixture of these options, retaining funds to further grow the company and paying out the rest to the shareholders. Dividends are most commonly paid in the form of cash. Many Canadian stocks pay a dividend and much of the money made in the stock market is in the form of dividends so it is important to learn how they work.

Dividends are paid out in a fixed schedule, usually quarterly, however some companies are paying out monthly. Companies can also declare a special dividend at anytime which is a one-time distribution.

Let's have a look at CIBC ** on October 7th 2011 after the markets closed (information is taken from Questrade):

Canadian Imperial Bank of Commerce (Ticker: CM)

Market Price: $73.50
Dividend: $3.60
Yield: 4.898%
Ex-Dividend Date: September 26th 2011

Dividend Growth Rate (5 years): 5.52%
Payout Ratio: 52.73%

Here are some of the key things you should look at when it comes to dividends. We'll go over each of them.

Market Price: The market price is the value of one share of the company. It fluctuates throughout the trading day depending on the supply and demand.

Dividend: This is the amount of dividends that would be received if the stock was held for a year. So if the company makes quarterly distributions you can divide this amount by 4 and that's how much you will receive every three months. Similarly divide the amount by 12 for monthly distributions.

Yield: The dividend yield is the amount of dividends you would receive as a percentage of how much you invested. Since it would cost $73.50 to get $3.60, the dividend yield is: $3.60/$73.50 * 100% = 4.898%. This is usually what I look at because it helps put into perspective how well the dividends are regardless of the dollar amount of the market price and the dividends. However the yield can also be deceiving so merely looking for the highest yield is not the best way to go about it. The yield of a particular stock may be high simply because the market value dropped. This may be due to many factors so find out why the yield is high before taking the plunge.

Ex-Dividend Date:  This is the date that any stocks bought are sold do not come with the dividend distribution. If I purchased shares of CM on or after September 26th 2011, I would not be eligible to receive the distribution. On the flip side, if I sell my shares on or after the ex-dividend date, I would still get the dividends even though I don't own the stock anymore.

Dividend Growth Rate: The dividend growth rate is the percentage increase of the dividend. In our example, CIBC has increased its dividends by 5.52% in 5 years. This indicator can be used to help paint a picture of how the dividends will look in the long term.

Payout Ratio: Remember at the beginning of this article we established that dividends come from the profits earned by the company. The payout ratio lets you know how much of the profit was used to pay dividends to the shareholders. CIBC has a payout ratio of 52.73% meaning that a little over half of what the bank earns is given to shareholders. Higher payout ratios are a bad sign because it means that there is less money to help the business grow. Also it is difficult for companies to sustain high payout ratios because the smallest setback in earnings will dip into the company's coffers (the money has to come from somewhere.) After a couple quarters of this, the company won't have enough money to pay shareholders forcing the company to cut dividends in order to save funds. There are many companies that have a payout ratio well over 100%, meaning that they give out more money in dividends than they are earning in profits. This is another indicator that I look at. Business can't keep a high payout ratio up for long so be careful when deciding whether or not you want to buy the stock.

Now let's wrap this up! If I purchased 100 shares of CM on September 24th 2011 what does that mean?

The position would cost me $7350 (plus commission charges). I can expect $360 in dividends if I keep my position for a year (or at least until the 4 payment dates). Since I bought the shares before the ex-dividend date, I can expect to receive dividends for the next distribution that the company makes.

There are many more indicators that can be used when analyzing a stock. Hopefully this will give you a general understanding with some of the terms that are used.

-the Paperboy

*I am by no means an expert and have no background whatsoever on the subjects other than what I learn on my own, so do not take the articles in this series as advice. Please remember to do your own research before making any financial decisions.

** Disclaimer: Long CM