What Are Dividends?

Even after years of studying and working in finance, the mention of dividends still reminds me of the little mustachioed man from the Parker Brothers Monopoly game—"Bank pays you dividends of $50!" As I recall, the little man is joyfully tossing his money in the air while kicking back at a desk with a rotary phone. It was always a little underwhelming, of course. Fifty bucks is a nice, but it doesn't count for much, even in Monopoly. It's not like landing on Free Parking, is it? And that's pretty much how we feel about actual dividends. But they do matter, and it's worth understanding why.

Most of us invest in stock these days in the hopes that the price of the shares will go up while we own them. I buy shares in Apricot, Inc. stock for $20 a share today because I believe that I can sell them each for $30 or $40 in a few years time. Simple.

But even while I am watching the share prices jump around in the market, the company I invested in is actually busy trying to, well, run a company. If Apricot, Inc. is doing this right, it is creating new products, expanding in new states or countries, keeping current on its debts and hopefully, making a profit. Notice that while all of this great, profit-generating activity can have an impact on the company's share prices, it can also be completely ignored by the people buying and selling stocks. After all, the shareholders will be completely happy if the share prices go up for any reason, even if the company itself is actually losing money. This, by the way, is the story behind a lot of the big social media and app companies today (I'm looking at you, Twitter).

All of this means that your average CEO is trying to run a company for the long-term while also making shareholders happy in the short-term. One of the tools at her disposal to appease shareholders is dividends. When a company has a profitable year, it can put the money back into the business, or it can declare a dividend. The dividend will go to all of the people who own a certain class of the stock. And the company can pay this dividend out in cash (which you can reinvest or use to update your rotary phone) or in partial shares, called a "stock dividend." If the company chooses stock or "scrip" dividends, then you as the shareholder will get an additional fraction of a share for every share you currently own. For instance, if you have 10 shares of Apricot, Inc., stock and Apricot announces a dividend of .05, you will get a new .05 of a share for each share you currently own, which brings your 10 shares up to 10.5 shares.

As you can imagine, people don't tend to get very excited about their new partial shares, but this is where reinvestment comes in. Many companies issue dividends every year, and these little bits of shares can accumulate fast. This doesn't help you at all if the share prices don't go up, or if company doesn't fare particularly well in the long-term. But then, you don't lose anything from the dividends in that case. But if you have chosen well, and your share prices really are going up over time, you won't just make money on the shares you originally bought—you'll be making money on shares you didn't have to buy.

And that, my friends, is why the little man with the round face and mustache is feeling so good about his dividend.