Still can’t think of a joke. Probably should have stocked them up earlier. Wait…
Lots of people have been asking about dividends. I apologize for not going in depth in the last post about dividends. So we are gonna delve into it a bit today.
First, I can’t emphasize enough what a stock actually is: it is a piece of the company you invested in, which makes you one of the company’s owners. Second, this is something I didn’t mention last time, a company that issued stocks is not obligated to pay dividends to the owners. Third, we have to understand that dividends come from a company’s profits.
With these three pieces of information in mind, let’s take a look at what happens when a company pays dividends and what happens when it doesn’t. Say you own 100 shares of Shike Coffee’s stock out of 1,000,000 shares that the company is worth as a whole. Shike Coffee makes a billion dollars for profit in 2015 and decides to pay dividends to its owner. You as an owner, gets 1/10,000 of the profits (100/1,000,000 = 1/10,000), that is 100,000 dollars. You are happy.
However, if the company doesn’t pay its owners dividends, and instead reinvest its profits into its business, let’s say CEO Alexander decides to buy a coffee farm in South America, the company could generate more profits for the next year. The 2016 company financial report shows that the company made 2 billion dollars of profit, and if the company were to pay dividends now, you would get 200,000 dollars. You would be happier. (Remember to take account of the time value of money, maybe you can make more money through other means.)
Of course, the company could decide to not pay dividends at the end of 2016 and reinvest the profits for 2017, and on and on and on… I know you, you might ask “If the company always decides to reinvest their profits, when am I ever gonna get the money that belongs to me?”
Mind you, the you are an owner of the company, and the value of your share of the company is increasing through the years because of these reinvesting. If Shike Coffee was worth 10 billion dollars at the beginning of 2015, at the end of the year it would be worth 11 billion if it didn’t pay the dividends. Your share of the company would be worth, 1,100,000 dollars. After purchasing the coffee farm, the 1 billion dollars spent is now an asset of the company that is worth 1 billion dollars. With the 2 billion dollar profit, the whole company would be worth 13 billion dollars, and your share would be equivalent to 1,300,000 dollars. Other investors see the company growing at such a steady rate would want its share because they believe Alexander’s brilliant decision making will one day make Shike Coffee the biggest coffee companies in the world. They would want a share of this company, maybe even for a price better than what the stocks are worth at the moment, perhaps 1,400,000 dollars. If you sold your share of the company at the end of 2016 for 1,400,000 dollars, then your profit from investing in Shike Coffee would be, 1,400,000 – 1,000,000 = 400,000 dollars, which is better than the 200,000 dividend payment.
So why do some companies pay dividends? Because investing in 1 billion doesn’t always yield a return greater than 1 billion. If the coffee farm Alexander purchased not only didn’t increase the profits for Shike Coffee but actually made it lose money, let’s say the local mobs took control over the farm, the 1 billion dollar purchase would actually decrease a company’s net-worth. Ok, that might have been a pretty extreme case. When a company starts to pay dividends, it doesn’t mean that it is in some deep legal issues. It usually means that the company is very mature and fully developed.
When a company cannot optimize its production process anymore and it has reached a full market, any more additional investments other than paying for the cost of production wouldn’t yield more profits. Then, the company would usually start paying dividends to its owners to keep them “interested” in the company. However, people usually read paying dividends as a sign of stagnation: the company doesn’t have a brighter future than it already does and the value of its stocks won’t go up anymore. Therefore, people would start retracting money from the company and invest in other “newborns.”
With money taken out, the company’s net-worth decreases and its stock price goes down. It will also need more money to keep it at the production level it used to be at. There’s a future for better; people get interested and start investing; stock price goes up again. Of course, this is a very coarse and ideal model of a company and stock, but in a way it explains how the stock market works and why do those lines we care about fluctuate.
Brandon asked me about how to decide whether to invest in bonds or in stocks. The situation he gave me is that he has 200 dollars of spare money, and I would presume that’s in the current economy. I think it is a good question for you to think about. Comment in the comment section if you would like to. I’d love to see how you would decide.
I heard that Roger has a pretty solid sneaker business, Lukas’ doing some crazy art work, and of course there’s the Shike Coffee, not yet a coffee tycoon. (That’s speaks of a lot of space for growth.) Maybe you would want to study them a bit… But then there’s also the senior class worrying about dinner dance money…
(Some active illustration of dividends: https://www.youtube.com/watch?v=aWSSrHVuUw4)