Imagine the village baker needs money for a new oven. You put in part of it, and in return he makes you a co-owner of his bakery, for a very small slice. At the end of the year, business has gone well. The baker rings your doorbell: "Here's your share of the profits. Thank you!"
That share is a dividend.
How does it work?
When you buy a share, you buy a small piece of a company. Each year, the company makes a profit (or doesn't). It then has two choices:
- keep it to grow: buy machines, open a shop, invent a product;
- pay part of it out to its owners: that's the dividend.
An example in numbers
Buddy owns 10 shares in a company, bought at CHF 100 each, so CHF 1,000. The company pays CHF 3 per share. Buddy receives CHF 30 in the year, which is 3% of what he put in.
Now suppose the share price rises by 4% a year on average and the dividend stays at 3%. Over 20 years:
- if Buddy spends his dividends, he'll have shares worth about CHF 2,190, plus CHF 600 of dividends received in total: about CHF 2,790;
- if he reinvests every dividend to buy more shares, his snowball grows at 7% a year: about CHF 3,870.
More than CHF 1,000 difference, simply by letting the thank-yous do the work.
In Switzerland, 35% withholding tax is deducted from dividends paid by Swiss companies; it can generally be reclaimed by declaring the shares on your tax return.
What researchers say
In the 1950s, John Lintner interviewed the bosses of American companies. He found that they hate cutting their dividend: they raise it cautiously, only when they're sure they can keep it up. A steady dividend is therefore often the sign of a confident company.
But beware of the illusion. Merton Miller and Franco Modigliani, two future Nobel laureates, pointed out that a dividend isn't money from heaven: when the company pays it, that cash leaves its coffers, and the company is worth a little less. A company that pays nothing but reinvests well can make its owners just as rich. A dividend is a thank-you, not a magic gift.
What to remember
Dividends reward those who own and who took the risk of financing a company. They're not a guaranteed wage: in a difficult year they can fall or disappear.
Try this tonight with your child
Play family business. Your child "invests" CHF 2 in homemade lemonade that you sell to the family at the weekend. After the sale, show them the two choices: take their share of the profit straight away, or put it back in the till to buy more lemons the following week. Let them choose, and compare the results in a month.
Further reading
- Lintner, J. (1956). Distribution of Incomes of Corporations Among Dividends, Retained Earnings, and Taxes. American Economic Review, 46(2), 97–113.
- Miller, M. H. & Modigliani, F. (1961). Dividend Policy, Growth, and the Valuation of Shares. Journal of Business, 34(4), 411–433.
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Educational content, not investment advice. Dividends are not guaranteed.