The Basics of Dividends

Let’s talk about the basics of stock dividends, what they mean, and how we look at dividends as Rule #1 investors.

What are Dividends?

Dividends are a distribution of a companies earnings to its shareholders, decided by the board of directors. They may be in the form of cash, stock or property.

Dividends are the money that the company pays out to its shareholders in cash.

For example, Coca-Cola pays about a 2% dividend. If Coca-Cola stock is, say, $40 dollars a share, 2% of 40 dollars is about a buck, .80 cents to a dollar and that’s what its dividend is.

A lot of people live on the dividends of a company. In fact, in the great depression, people thought that the only value of stocks was the value of the dividend being paid out because stocks weren’t going up they were going way down.

How to Look at Dividends

When we look at dividends as Rule #1 investors, we look at it very differently than most people do.

We see dividends, not as a return on our investment of 2% or 3% a year, we see it as a simple return of our capital.

We’re looking to get our money off of the table.

Using Dividends to Lower Risk in Investing

We want to lower our risk every year by receiving dividends, so that reduces the amount of what we call basis every single year. As our basis goes down every single year, our risk of owning that business goes down. If the dividend is very high, let’s say 6% a year, then in 10 years we might have removed 60% of our risk off of the table and we have a very low chance of losing money on that investment.

So dividends to a Rule #1 Investor are a way to reduce basis, get your capital off of the table, and lower your risk.

Thanks for reading! Leave a comment below and join the conversation.

Now go play.

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About Phil Town – Phil Town is an investment advisor, hedge fund manager, two-time NY Times best-selling author, ex-Grand Canyon river guide and a former Lieutenant in the US Army Special Forces. He and his wife, Melissa, share a passion for horses, polo and eventing. Phil’s goal is to help you learn how to invest and achieve financial independence. You can follow him on google+, facebook, and twitter.

  • Garrett

    Hi Joe R and Rulers,

    Thanks Joe R for taking the time to post your comment in both of Phil’s headlines – Generally, I’m pretty good at staying up on reading 100% of the comments, but it helps!

    Regarding your thoughts on Trading VS Investing – another thing that occurred to me is I don’t box myself into being just a trader or just an investor. There are times that I’ll enter a position with the goal in mind that I’ll be trading it or investing in it.

    But the problem I’ve seen Newbie Rulers do is they’ll start with the idea of trading and then when it goes lower, they rationalize and say, “Well, I guess I’m going to stockpile this now that the price has gone down so much.”

    Not a fun or successful strategy to have!

    For example, Bed Bath and Beyond – My plan was to trade it from the very beginning. Why? Well, in that particular situation, I had larger amounts of money committed to other companies and if BBBY’s price started to drop substantially below my first entry, I didn’t want to be in a situation where I had to sell other positions to raise more cash in order to start lowering basis. In fact, with BBBY, I believe I bought in just twice.

    Recently, I had a brief email exchange with Phil and he shared how he’s really stressing “digging deep” into the research with his students and making sure we all do our own homework. Now, don’t confuse that with thinking you have to go it alone. In Investing, if you ain’t cheatin’ you ain’t tryin’!! I ALWAYS read other people’s homework. What you want to do is make sure you can UNDERSTAND what the Seeking Alpha contributor is saying. Investopedia helps a lot when trying to understand some financial terms.

    MEANING is very important and I don’t invest in everything that Phil invests in. I have no idea how much or how little Phil is buying of a particular company. What has MEANING to him may not have MEANING to me. But what I do care about is understanding how Phil thinks and the questions he’s asking himself about a company and how he’s creating his Story for the biz along with his 4M Analysis. Phil writes it all out: MEANING, MOAT, MANAGEMENT, MOS…The Event that put it on sale, whether Mr. Market is acting rational/irrational, what the EVENT is that created the FEAR that put XYZ on SALE – then we have to determine is this temporary or permanent…yada, yada, yada…lots of number crunching to come up with a good VALUE to ensure we’re buying with a Margin of Safety.

    Much of the quality of your investments and your returns will come down to the quality of the questions you can ask yourself and the ability to find those answers.

    Phil asks simple questions about a company that at times may have very difficult answers because the business is more complicated in some way or another. Even Buffett has a “Too Hard” pile that he might have to look at later.

    For me, if it’s too hard, then I just PASS. I don’t need to be a genius to know that Panara makes a great sandwich and can grow anywhere from 12% to 15% with little problem over the next 10 years. The skill is knowing when to buy them at a basis of $145 in July and then selling them three months later at $170…17% in 3 months would be pretty darn nice, yes?

    Getting late so gotta go!

    To Your Wealth!
    Garrett

  • Phil Town

    For clarification: Buffett invested when IBM was between $159 and $190 with an average of about $172.

    Also please remember to not invest in anything that isn’t in your ‘canyon’ where you are an inch wide but a mile deep in knowledge about the company and the industry. Have you read 5 years of 10Ks and every single SeekingAlpha article and all the quarterly transcripts for this company and its competitors? If not, keep digging.

    Also also, it is a big deal to know that there is an Event that put the business on sale. If you think its on sale but there is no Event, then you must think you are smarter than Mr. Market. That is a very dangerous thing to think. Our advantage is not IQ. Our advantage is that we don’t answer to skittish pension managers and wealthy investors, therefore, we can buy Fear while the big guys have to sell it. If there is no Event, there is no Fear. If there is no Fear, be afraid … be very afraid.

    • Mike Mac

      Is there an event occurring right now? Maybe. Russia and oil dominate the news. The Ruble is weakening every day. The converse of that statement is to say that the dollar is getting stronger and stronger, which is a deflationary condition. The FED wants an inflationary environment – a 2% target which is not happening in this environment. What’s the likely outcome? People expect a taper of QE3 and a rate increase in the US. Smart people I follow say its more like that QE3 comes to a close and then the Fed will turn around and start QE 4 in 2015 to pump more dollars into the system. This also means its unlikely that we will see an interest rate increase.

  • Scott

    Looking forward to BP’s and Exxons earnings calls….I’d love to sell some rule#1 puts on BP but my tax sheltered account won’t allow it!!!

    • Scott

      Hello,
      I’m currently taking Jeff Towns course and went through a weekend course in Atlanta a few months ago (August). I’m not sure who’s moderating this site but I’m blocked from taking part in discussions – could someone let me know why that is happening please?

      Thank you.

      Scott

  • Garrett

    Rulers,

    There are some companies that don’t pay a dividend that I hope to own for a very long time. DeVita Healthcare is one of them – it’s a significant portion of Berkshire’s holdings.

    The following article is a good study on understanding more about dividends. If you’re a serious Rule #1 Investor, it would be helpful to click the link, print it out, study it and then read the subsequent comments. It’s a Seeking Alpha article I read last year from “Early Retiree” – a Seeking Alpha contributor. I love reading his stuff.

    I originally re-posted it on the blog for you, but the tables didn’t line up correctly, so here’s the link:
    http://seekingalpha.com/article/1939941-should-berkshire-hathaway-finally-pay-a-dividend

    Enjoy!
    To Your Wealth!
    Garrett

    • Joe R

      Awesome comments Garrett. Re trading versus investing
      after reading all of phils books and blog posts, I’m having a hard time deciding if I want to be a rule 1 trader or stock piling. On one hand value investing and stock piling is the proven way. Buffet, munger, pabrai, spier, klarmam etc didn’t become legends by trading in and out of companies. They bought companies and held them and occasionally sold them once they hit value or stopped being wonderful.
      On the other hand we have a record high and fed support with crazy low interest rates. A perfect storm to trade and make some money before the “music” stops and the inevitable draw down occurs. But again this goes against the tried and true value way. Dilemma indeed.

  • Jason Maranhao

    Does Rule #1 Investors reinvest the dividend or take the cash?

    • Mike Mac

      I personally default to reinvesting the dividends. Why? Because we should be buying stocks/companies when they are on sale, so we’d want to keep picking up more shares while it is still on sale. If your stock is in the red-zone and getting above fair value, you might want to switch it to a cash distribution so as not to be buying a fully valued or over valued stock.

      • Garrett

        That makes sense. When you’re in the “Green Zone” – i.e. – at or below your known MOS price, it’s hard to be wrong.

        The only thing that gets scary is when you buy at your perceived MOS price and the price drops 20%…then you start wondering if you’re a moron and totally screwed up – yeah, been there and done that.

        I find lots of solace in the fact that EVERYONE makes investing mistakes even after they’ve done as much homework and research as they can.

        I also find solace in the fact that you can recover from those mistakes.

        To Your Wealth!
        Garrett

        • Mike Mac

          Just be thankful that 2 years ago we bought into Cliffs above $50 and got out with a gain in the $60, and decided NOT TO STOCKPILE on the way down….to today’s price around $7 bucks. I liked it at the time, but something didn’t feel right. Sometimes it’s best to listen to our gut!

  • Mike Mac

    Speaking of dividends, I wonder if Ensco (ESV) will cut its dividend which is now over 10%. BP is now over 6%. hmmm. We don’t like dividend cuts. We like dividend raisers.

    • Garrett

      Hi Mike Mac and fellow Rulers,

      I’m fully expecting BP to decrease their Div payout so that it drops from today’s current div yield of 6.62% back to about 4.5% – 5%.

      For our Newbie Rulers, we figure out our Dividend Yield by taking the annual dividend payout which we can look up and see it’s $2.40 per share and divide that by BP’s current price, which is $36.25.

      $2.40 / $36.25 =’s 6.62% dividend yield. And we can see that if the Div were to remain at $2.40 and the stock price goes down…then the return goes up.

      So what would BP’s dividend look like if they decreased it so that at today’s current price it only gave a 5% Dividend yield?….. 5% x $36.25 =’s $1.80 per share.

      Oil prices are just nose diving. To me, it’s very clear we are in an Oil Market Share War. The Saudis have refused to decrease output and now US Balkan Shale and Canadian oil sands will be forced to shut down wells. Russia’s economy will struggle for awhile as they pump oil at significant discounts.

      Eventually, things will normalize as competition dwindles and prices stabilize – but it will be ugly and the ride will be full of bumps and fear-mongering headlines The one’s left standing will clearly have their stock prices depressed, but they’ll have bought other companies at fire sale prices. When its all said and done…who knows how long it will take…there will be some major winners. Our job is to buy the best company on sale that’s loaded up with lots of cash to make good on these future bargains and then wait for Mr. Market to bid the price back up.

      Be patient! We’re going to see some fantastic bargains. Exxon is about the world’s 4th largest energy company and BP is about the 6th largest. These guys are not going to go bankrupt. Royal Dutch Shell is about the 7th and Chevron is about the 9th largest.

      Remember, Buffet is invested in on Exxon at about $90 when oil was $100. Today, we broke that floor and the odds are we’re heading for lower lows with Exxon busting through the $90 Buffett Floor.

      Since we haven’t found a bottom on West Texas oil, I’m patiently waiting before I pull the trigger on BP or Exxon. I got out of BP when it broke $45.00 hoping I could load up at a much better price. So far, so good – I’m still waiting for a bottom and when one appears I’ll start buying 1 of 4 or more tranches.

      We won’t see BP’ or Exxon’s 4th Quarter results till end of Jan or very early Feb. It’s definitely going to be a MUST READ/MUST WATCH earnings conference call. We’ll see a lot of volatility in the options markets as we approach earnings.

      There will be some great Oil and Oil Service/Rental equipment companies available huge discounts if this continues. Remember, Wall Street can’t wait 6 months or a year for something to get better. They’ll dump it. But we can. We don’t have to report our results to anybody. And if that means we sit waiting a year or more for our investment to finally get recognized by Mr. Market – so be it.

      There will be some FANTASTIC companies on sale as this Volatility and Uncertainty as the Oil Market Share Wars continues. These are the moments we Rulers wait for! Now is the time to do your homework and read lots of earnings reports/seeking alpha articles so if a good opportunity presents itself you’ll be ready.

      To Your Wealth!
      Garrett

      • moncho

        I second Garrett’s post. In addition, with oil trekking in a downward spiral, be on the watch for many US fracking companies and those that supply equipment/supplies to them.

        I have just started initial research on Helmerich & Payne Inc (HP). I heard about them a few years ago but did not do much digging. I ran quick numbers a few times but it seemed to expensive. With the huge drop in oil prices and seeing what plays out over the next couple months, especially with the higher cost per barrel US land based oil drillers, I think HP may be worth a more intensive look.

        I am also on the look out to see if Exxon and the rest of Big Oil to see if they pick up some highly leverage US frackers at bargain prices. Some may need help paying off their loans and may be willing to sell large percentages of their business to help pay back the banks.

        Moncho

        • Mike Mac

          I bought some HP. Hope it dips below 60 to buy my next batch.