Dividends 101

Quick: what is the difference between income and principal? While most people know vaguely that principal has to do with what you originally deposited in an account, and income is what is paid on that principal, these definitions can get pretty muddy over time as values in your account change.

Let’s say you deposit $100,000 in an investment account, and you buy ten stocks. All of them rise 10%. You now have $110,000. Is that extra $10,000 income, or principal?

It’s principal. So although you can think of principal as what you originally deposited, that value changes over time. In tax terms, the $10,000 is capital gain, but it’s still part of your principal.

Now let’s say that all ten stocks pay you $1 in dividends (to keep it simple we’ll assume that no matter how many shares you own, each company’s dividend totals $1). That’s another $10. Is that income, or principal?

It’s income. You can spend that, and still maintain your principal.

Now that we have defined income and principal, let’s delve into where that $1 comes from.

Every public company has a board of directors, and it’s up to that board to decide upon and declare a dividend on the company’s stock. So at a director’s meeting, someone will present the company’s financials, talking about how well operations are going. If things are going particularly well the board may decide it’s time to raise the company’s dividend. So instead of $1, the board may decide to pay $1.10.

Where does the dividend come from? It comes from the company’s cash flow, which it generates from selling goods or services. NOTE! that the payment of the dividend has nothing to do with the company’s SHARE price, only whether its profits are enough to pay the cash out to shareholders. So even if the company’s stock sinks in value, the $1.10 payment will still be made.

Now if a very bad recession hits, dividends may be reduced or eliminated. Sometimes a company runs into trouble even without a recession, and has to decrease its dividend. But for the most part, once the Board declares a dividend at a certain level, it is loathe to decrease it. So most of the time, there’s margin of safety around the dividend, assuring that the company can pay it even if times get lean.

So what does this mean for your portfolio? Well, your $110,000, which is generating $10 in income, could sink to $80,000, but it would still generate $10 in income, provided you own high quality companies. And you can see that growth can come from two places in your portfolio – principal, when stocks go up; and income, when the board of directors increases dividends. That’s why stocks pack such a powerful punch over the long term, despite being occasionally vexing over the short term.