Welcome to "How does that work?" and the first article in this new blog category!
Dividends are payments that companies distribute to their shareholders. By owning a share, the shareholder acquires a share in the company. As a shareholder and stockholder, this entitles you to a share of the company's profits. This amount is paid out by many public limited companies in the form of dividends and is usually paid out once a year. In the USA, however, there are also some companies that pay dividends on a quarterly basis, such as Apple, Microsoft or IBM.
The amount of the dividend depends on the company's profit and the number of shares it owns.
What is the function of dividends?
When a company makes profits, it may decide to distribute part of those profits to the shareholders. At the general meeting, the amount of the dividend is decided together with all shareholders entitled to vote. As a rule, the proposal, which is announced in advance, is also approved at the general meeting.
For example, this year Hapag Lloyd decided to distribute a large part of the extraordinarily high profit from 2022 to the shareholders. 63 euros per share were paid out. This means that someone who, for example, had 2 shares worth only about €500 in his or her securities account on the dividend record date received a payout of €126.
However, this does not mean that this shareholder now has the share value of approximately 500€ plus the 126€ more in his account. When the dividend is paid out, the share price also falls by approximately the amount of the dividend.
What is the reason for this? The company loses a lot of its value by giving a part of its profit to its shareholders.
Let's stay with the example of Hapag Lloyd:
With a profit of about 17 billion euros, Hapag Lloyd paid out about 11 billion euros to its shareholders. At the time, the company was only worth about 50 billion. So the 11 billion euros that are "gone" in one fell swoop and reduce the company's value are relatively significant. This is reflected in the fall in the share price (= market capitalisation falls).
Share purchase programmes
Companies also have the option of conducting share purchase programmes. Here, the company buys back its own shares instead of paying dividends. This leads to a reduction in the number of shares in circulation. By buying back its own shares, the available quantity thus decreases and the value of the remaining shares on the market (supply and demand) usually increases accordingly.
Share purchase programmes can be used as an alternative to dividend distribution and also offer financial advantages to shareholders.
Benefits of dividends:
Regular income: Dividends allow shareholders to earn steady income from their share investments. This can be an interesting model especially for retirement provision. For example, someone who has saved up €100,000 before retirement could use dividends (2-3%) to increase his pension by €2,000-3,000 a year and, for example, use it to finance a summer holiday each year.
Stability: Companies that pay dividends are often seen as stable investments, as they usually have solid business models and stable profits. This can help reduce the risk of an equity investment.
Disadvantages of dividends:
Limited growth potential: Companies that pay dividends use part of their profits to distribute to shareholders. This leaves less capital available for investment in the company, which can limit growth potential.
Price volatility: When a dividend payment is announced, the share price usually falls by the amount of the dividend.This is because the value of the dividend is deducted from the share price. The associated share price volatility can unsettle investors who realise that the value of their shares is falling. Particularly in the case of high dividend payouts, a drop in the share price of 10%, for example, can be frightening at first glance. As a rule, however, these effects are minimal, since there are usually also many "rational" investors (such as large funds, for example) in the respective company who do not show such startle reactions.
Dividends are a way for shareholders to benefit from their share investments. They provide regular income and can be a source of financial stability. Nevertheless, they can limit a company's growth potential and lead to share price volatility. Companies also have the option of conducting share purchase programmes to provide financial benefits to shareholders.
It is important to consider the individual advantages and disadvantages of dividends and share purchase programmes and evaluate them in the context of your investment strategy. This understanding can help you make sound stock investment decisions and enhance your financial knowledge.
Finally, I have a small question for you, which you are welcome to answer from the perspective of a shareholder:
Note: Of course, the decision depends on what goal you are pursuing with your investment and it can also make sense to have both companies with extremely high dividends and no dividend payments at all in the portfolio.
Please feel free to use the comment function if you would like to explain / discuss anything else.