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That quote right there is from none other than John D. Rockefeller, American industrialist, tycoon, and, apparently, the namesake of Tina Fey/Alec Baldwin star-making sitcom 30 Rock. Dividends are the bread and butter of any early retiree. You know all that stuff we write about living off passive income? This is what we’re talking about. New readers, please click here to start from the beginning.
How Dividends Work
So how do dividends work? Basically, when a company makes money, they have a few options of what to do with that money (after paying employee salaries). Namely:
- Re-invest in the company (by buying more equipment or hiring more people)
- Sit on the cash and do nothing
- Distribute it to its shareholders
But wait, why would they give it to shareholders when they could do #1 or #2? Well, first of all, sometimes there isn’t a great opportunity to reinvest it (for example, no physical place to put new equipment), or they’re making SO much money they can’t spend it fast enough (I’m looking at you, Coca-Cola!)
Second of all, a company sitting on a lot of cash is a bad idea. This is me getting into Gordon-Gecko-Wall-Street-Trader mode, but basically companies with a large cash balance are vulnerable to a hedge fund swooping in and buying the company out. This is called a hostile takeover, or a leveraged buy-out. If you were a corporate raider, you would LOVE companies holding a ton of cash. Why? Because you could convince some bank to lend you lots of money, buy the company, fire everyone, take the cash (and any hard assets like real estate, equipment, etc.) to pay off the loan, and then run off cackling as the company burns to the ground.
So in a strange twist, having a healthy cash balance is great for personal finance, and a terrible idea for corporate finance.
BUT, the CEOs and executives of a company are usually significant shareholders themselves. So by distributing cash as a dividend, a CEO can reward himself by transferring money from the company into his personal bank account. At which point it then becomes converted into cocaine.
So that’s why companies pay dividends. And this also applies when you own a broadly diversified Index-tracking ETF like the ones we own. Remember, when you own an Index ETF, you are owning shares of all the underlying companies themselves. So when they pay a dividend, it goes to the ETF, who then turns around and divides it among its shareholders.
Now a few important things to know when evaluating an ETF’s dividend yield:
Calculating a fund’s dividend yield can get confusing. This is because each stock’s dividend is decided on by that company’s board of directors like “Company ABC will pay $0.08 a share every quarter.” In other words, dividends are declared as a certain amount paid per unit.
A stock’s dividend yield is defined as:
Annual payout/ stock price
So, for example if stock ABC’s price is $6 a share and dividend payout is $0.08 x 4 = $0.32.
Then the dividend yield is $.32 / $6 = 5.33%.
But in case you didn’t notice, a stock’s price can change quite a bit. That’s why there are confusing yield numbers listed on an ETF’s summary page that can differ by a lot. For example, at the time of this writing, the EAFE ETF run by iShares has a trailing 12-month yield of 1.62%, and a project distribution yield of 3.24%.
So what gives? The answer lies in the definition of each metric.
The 12m Trailing Yield is: “The yield an investor would have received if they had held the fund over the last twelve months (assuming the most recent NAV).” NAV means Net Asset Value, or the price of ETF share.
If the price of the ETF went up over the last year, it’s 12m trailing yield would get hammered. This is because the money paid during the year is being compared to its new, higher price. And sure enough, XEF went up last year.
So what you want to look for is the current yield projected forward at current prices. This is because your personal yield is determined at the time of your buy.
If you buy an ETF yielding 5.33% and its yield collapses to 4% because the price went up, that only affects new people buying the fund. Your yield was locked in when you bought, and assuming the underlying companies don’t drop their dividends, you get paid the same dividend.
So using the example above, if you bought the ABC stock at $6, with a yearly dividend payout of $0.32, your personal yield is 5.33%. If the stock were to go up to $8, you would still get paid $0.32, even though the yield for new buyers is now only 4%.
So the important metric for you is the Projected Yield. In the US this is called the SEC yield.
Another important date to look out for is the Ex-Dividend date of your ETF. This can be found by going to the Dividend Calendar of your particular fund (we showed you how to do this in a previous article). In that calendar, you can see each fund’s Ex-Dividend date.
So what is an Ex-Dividend date?
You must be in possession of this fund on this date to be eligible for its dividend payment. And by “in possession,” I mean you’ve bought the ETF and the trade has settled. Here’s the dividend calendar for the Vanguard Bond Index, BND.
So the last dividend payment is defined by: the Record date and the Ex-Dividend Date. The one you care about is the Ex-Dividend date. As long as you are in possession of that fund on 12/29/2016, you will get its dividend.
The Record Date is the date you have to “register” your ownership of that fund, but that happens automatically when you buy your ETF through a brokerage account, so for all intents and purposes, the Ex-Dividend date is the only date you need to care about.
And DON’T think you can just buy the ETF the day before the Ex-Dividend Date, collect the dividend, and then sell the day after. People have already thought of that. Here’s what really happens. In the absence of news that moves the ETF’s price, the price of an ETF will tend to rise by its dividend amount coming up to the Ex-Dividend Date. This is because owners of the ETF are not willing to sell right before collecting their dividend unless they get compensated for it.
Free market, bitches!
Once your rightfully-deserved dividend is recorded on the Ex-Dividend date, there is often a delay until you actually receive your check. The day you actually get your money is recorded as the Payout Date, named after, unsurprisingly, the date that you get paid out.
The day after is also recorded as “Cocaine Day,” but we won’t talk about that too much in this article.
That’s All Folks!
And that is it for this week. See you all next Wednesday. Peace out, yo!
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Disclaimer: The views expressed is provided as a general source of information only and should not be considered to be personal investment advice or solicitation to buy or sell securities. Investors considering any investment should consult with their investment advisor to ensure that it is suitable for the investor’s circumstances and risk tolerance before making any investment decisions. The information contained in this blog was obtained from sources believe to be reliable, however, we cannot represent that it is accurate or complete.