How Dividends Work

As mentioned in an earlier post, dividends represent a portion of a company’s profits.

 

For example, let’s assume that ABC Company has issued a total of 100 million shares, which are owned by thousands of individual ‘retail’ investors, pension funds and mutual and other funds as well as company directors. If the shares are currently trading on a stock market for $50 per share then the company has a market capitalization or ‘market cap’ of $5 billion (100 million shares X $50 per share = $5 billion), making it a large mid-cap company. If the company earns a net profit of $500 million then this equals $5 per share ($500 million ÷ 100 million shares = $5 per share). If the company has a ‘pay-out rate’ of 50% then $2.50 of the $5 profit is issued as a dividend to shareholders for each share they own, while the remaining $2.50 is retained internally to fund company growth.

 

The $2.50 divided by the share price of $50 = 5%. This means that ABC Company’s shares ‘yield’ 5%. If you own 20 shares of the company your cost to purchase the shares is $1,000, and with a 5% yield you earn $50 per year as a dividend for owning part of the company. Because the company pay-out ratio is only 50%, it has retained the other 50% of its net profits of $250 million ($2.50 per share) to use for research and development, market expansion, acquisitions or other activities that result in growth. Over time – barring some sort of catastrophe – this should mean that the value of the company increases, and thus its share price will also appreciate. Then if you sell your shares at a future date you will (probably) make a capital gain, and in the intervening time you will have been banking dividends paid in cash.

 

So What Does this Mean for the Child Millionaire investor?

Our Child Millionaire portfolio is comprised entirely of shares in high-quality dividend-paying companies, because these companies provide the best of all possible worlds. They are usually serious, even dominant players in their sectors; they often have global reach and can tap into fast-growing markets; and unlike small, riskier companies, they are paying you to own them in the form of dividends.

 

Historically, research shows that dividends matter more than almost anything else in stock market returns over time and dividend-paying shares dramatically outperform growth shares over time. They matter so much that the entire Child Millionaire portfolio system is built on them. In fact, without dividends it would be difficult, if not impossible, to create a Child Millionaire. As an investor you should never, ever, buy a share if it doesn’t pay a dividend, otherwise you are simply gambling.

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