Dividends

As some of you know, I teach a BRILLIANT online course on stock valuation and analysis. I say it's brilliant not to brag, but because it really is brilliant, there's nothing like it in college. It covers not just how to read financial statements and how to calculate ratios, but picks up where colleges fail and TEACHES YOU VALUATION TECHNIQUES. YOU SHOULD TAKE IT.

In any case, I had a student ask a question about dividends, the answer to which I realized would be of benefit to all the Cappy Capites out there, not to mention the everyday Joe's who are having a hard time understanding why their 401k isn't skyrocketing through the roof during these glory days of hope and change.

So I submit to you more of my economic genius;

Yes, everything you stated is correct. To clarify though what drives the value of a stock or what it is you are precisely selling to another buyer on the second market, let me further explain.

What you own when you own a share of stock is the right to the proportional earnings of that corporation. Now, of course not all companies pay out their earnings in the form of a dividend. They will retain ALL of the earnings and reinvest them back into the company.

Now you would say, "well then why should I own the stock if they NEVER pay a dividend."

And you would be correct. If a company NEVER pays a dividend, then that stock has no value. You just gave the company (or secondary market seller) money for a piece of paper that will never give you money in return.

However, companies inevitably DO pay dividends. The reason they retain earnings and not pay dividends is to grow the company so they can earn even MORE money in the future.

Now this is where investing philosophy gets cute. Companies are typically very arrogant about paying dividends. They ALL think they're going to grow into huge multi-billion dollar behemoths and then, MAYBE THEN they'll pay you serfs some pittance of a dividend. Of course what is more likely to happen is they inevitably go belly up. What they SHOULD do is when times are good is pay out some of their earnings as a dividend otherwise the stock IS worthless.

Now what's interesting (and scary) about this, is it shows you a MAJOR flaw in today's conventional retirement system - everybody buys stocks because they "might go up in the future," not because they pay dividends. Well the question is "what drives stock prices up?" And the answer is scary;

Only dividends can drive stock prices up.

The reason why is when you sell a share of stock, yes you may have made a gain, but why did that buyer buy it from you? Well, because today or in the future that stock will pay dividends.

No matter how many times a stock is bought or sold, it only has value because either today or sometime in the future it's going to pay a dividend. So you are essenitally selling the right to future dividends when you sell a stock. Ergo, dividends (or the likelyhood dividends will be paid) is what drives stock prices.

So what this means is you currently have 100 million Americans all throwing their money into 401k's and IRA's and 403b's NOT because all these companies are paying great dividends, but because they magically think "stock prices just go up" for random magical reasons.

This is why you will want to DEFINITELY look at the "dividend yield" of a mutual fund or a stock before you buy it to make sure there is real cash flow associated with the stock and giving that stock something of value.