Back to School: Dividends 101

Get to know one of the coolest forms of income with Ian Tam and our guest host, Ethan Lu

Ruth Saldanha 4 September, 2020 | 12:48AM

 

 

Ethan Lu: Hello, my name is Ethan Lu and today I'll be talking to Ian Tam about dividends.

Hi, Ian.

Ian Tam: Hi, Ethan. Nice to meet you.

Lu: So, getting straight into the questions, I want to know a bit more about dividends. So, what are dividends?

Tam: It's a good question, Ethan. Maybe a good way to explain that is to pretend that you are opening a business yourself. Ethan, do you like hamburgers, for example?

Lu: Yes.

Tam: Perfect. So, let's say that you are opening a hamburger business and the first thing you're going to want to do is buy the ingredients to make hamburgers. So, you might go and ask your mom and your dad or your investors for some money to go and buy the supplies to make those hamburgers. Then, you're going to make those hamburgers and then you're going to sell them maybe to your friends for some sort of a profit, right? So, let's say, it only cost you $2 to make the hamburger but actually you sell it for $5. A dividend is like giving $1 back to your parents for investing in your hamburger business to begin with. So, in a nutshell, that's how I would explain a dividend.

Lu: All right. So, why would companies pay for dividends?

Tam: Yeah, so companies tend to pay dividends, number one, to show their investors that they are actually adding some value or getting some profits. So, in the example we just talked about, by giving that $1 back to your parents, let's say, a day later, so maybe next day, you want to make some more hamburgers, by giving your parents that $1 in the first day, it gives them some faith that you're going to continue to be profitable in your second day of business so that they will continue to invest in you in the future. So, basically, by paying dividends companies are showing their shareholders that they are adding value and actually gaining a profit.

Lu: Oh, I see. So, why do investors like dividends?

Tam: Yeah, so if you think about it from – in that example, if you think about it from your parents' perspective, they've given you some amount of money and after just the first day of business, they've already received some of their investment back and that's very attractive for an investor. You're getting a yield, so to speak, on your investment. And that's one reason why investors prefer to invest in companies that pay dividends. The second reason is because companies that pay dividends tend to be a bit larger in nature. So, they tend to be very big companies that are a bit more steady so that they are able to afford a dividend or a cash payment to their investors. So, it may not always be the case, but it does tend to – at least in Canada we do tend to see larger quality companies pay consistent dividends over time. So, that's the reason why it's attractive for investors to seek dividend-paying companies because they do tend to be a bit more stable, at least broadly speaking.

Lu: Okay. So, can you still get dividends if you invest in a mutual fund or an exchange-traded fund?

Tam: Yeah, great question, Ethan. Investing in a mutual fund or an ETF is just like investing in a portfolio or many different companies. So, let's say, you had 10 brothers and sisters and each of them want to start a hamburger business, basically your parents by giving each one of them some money for their business is like investing in a fund or a portfolio of stocks. And certainly, investors' portfolios are entitled to the same dividends as investors for a single company. So, definitely, mutual fund and ETF investors certainly have the right to dividend payments just like a stock investor would.

Lu: Okay. So, thank you for your time, Ian. I feel like I have a lot more knowledge about what a dividend is. For Morningstar, I'm Ethan Lu.

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Ruth Saldanha

Ruth Saldanha  Ruth Saldanha is Senior Editor at Morningstar.ca

 

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