I realized the other day that, despite my dire hopes to the contrary, the concept of “investing” is still foreign to many people—particularly young people. I suppose this shouldn’t come as a big surprise. “Stock Market Investing” and especially my much-touted “Dividend Growth Investing” isn’t part of the government’s high school core curriculum, and those schools that do provide it are probably doing so in more of a “personal finance” or “business law” fashion (two courses that I did take in high school). So, in a fun and concise way, I’m going to give you a cradle-to-grave synopsis of what dividend growth investing is.
First, we need to understand what a business is.
1. Eric Starts a Business
I’m standing in my garage one weekend, drinking a beer and staring mindlessly when I decide, “I’m going to make some money on the side!” I look at the grass outside and think about how much I like to cut grass. I go on the internet and apply for a Federal Tax ID number and register my business in Virginia as a sole proprietorship called “Eric’s Lawns.” I open a business checking account and deposit $100 of my own money to buy one lawnmower and a tank of gas. I get 100 free business cards on Vistaprint and start puttin’ them joints on car windshields at the mall. I’m cutting lawns at $10 a pop. I own 100% of the business.
2. Eric Expands His Business
Six months pass, and business is pretty decent—but I’m stretched thin. Clients start asking for me to do edging, landscaping, fertilizing…I can’t take it! I need to hire somebody to help me out. I also then need a second lawnmower, weed eater, and a trailer for the car to haul it around. I also need to hire an Accountemp for an hour a month to update the Quickbooks ledger. I need $1,000 to do all of this. I don’t have $1,000 at the moment, so I ask my buddy Dan for some money. He says, “sure, I’ll lend you some cash.” I say, “I don’t want a loan. God knows I never paid you back in high school. How about I give you a piece of ‘Eric’s Lawns’ and you will be entitled to a share of the profits?”
Dan mulls it over, I show him how many lawns I’ve mowed and how many clients want me to do extra work, and we agree that he will give me $1,000 in exchange for 50% of the business. From here on out, Dan gets half the profits, I get the other half.
loses his hand in lawnmower accident Branches Out
Word of mouth is spreading. People like our work and at our $10 price point we’re underselling even little Billy Vandelay down the street—we’re puttin’ that little dude straight outta business! I start getting calls from other towns who want “Eric’s Lawns” to set up shop there, too. I simply don’t have the bandwidth. Plus, the wife is naggin me to be at home more to rub her feet full time. So I want to get outta the game. To do so I need to hire a manager and a fleet of 20 employees to set up operations in ten different cities. I need $100,000 in order to do all of this. I go on “Shark Tank” and Mark Cuban agrees to give me the money in exchange for a 40% stake of equity. So, Cuban owns 40%, I own 30% and Dan owns 30%. We get the $100k and start expanding….
Now, we need to find out how businesses get turned into ticker symbols.
4. “Eric’s Lawns” Files For an IPO
Demand is off the chain. We’ve been using profits to hire and expand and now, collectively, we’re mowing 100,000 lawns per year at $10 each—a cool $1 Million in yearly revenue. After salaries, expenses and taxes, we’re profiting $500,000 (50% Profit Margin!!!). Given that sky high profit margin, we decide to go global. We want to set up shop in 100 cities across both the United States and The Democratic People’s Republic of Korea. We need big dollars to do all of this; we need $10 Million. Well, the Mark Cubans and other venture capitalists of the world want too much equity for giving up that much money. We need to get a lot of smaller investors that are willing to give us small amounts of money in exchange for a smaller ownership. We don’t have the time to find all these people, so we call up the New York Stock Exchange (1-800-MAKE-$$$) and ask for a listing. They roll out the welcome wagon. We do a coast-to-coast roadshow enticing would-be investors to buy shares. We offer 5 Million Shares at $2 each (netting us $10M). That entire 5M batch of shares represents 50% of the company (each share is .00001% of the company). The other half of the company is also broken up into 5M shares, with Cuban owning 2M (20% of overall company), and Dan and I each own 1.5M (15% of overall company). Therefore, the whole company is made up of 10 Million Shares.
Goldman Sachs underwrites the offering. Meaning, Goldman writes us the check for $10M, and it’s on them to sell those shares to the open market or privately place them to their own investors. We ring the opening bell on the NYSE, and “Eric’s Lawns” (ticker ELWN) starts trading for $2/share. My 1.5M shares is now worth a mouth-watering $3 Million. I sell 5,000 of those shares in to send Dan some food money, as he just sold all of his 1.5M shares to put a down payment on a 274-square-foot pre-war, no-laundry-in-building, sixth-floor-walk-up studio apartment in the rough part of Manhattan (it even comes with three roommates and two vagrants).
In a very crude manner, I’ve just displayed how companies form and end up on the New York Stock Exchange.
5. Little unemployed Billy Vandelay (Remember Him?) buys 100 Shares of ELWN in his E-Trade account
Our young friend Billy is still sore from being put out of business, but he recognized the value that “Eric’s Lawns” brought to his community and many other communities around the country. He bought 100 shares at $2 each (a $200 investment). Little Billy is now an investor.
Next, we need to know what a dividend is.
6. “Eric’s Lawns” Decides What to Do With its Profits
“Eric’s Lawns” mowed a million lawns last quarter, ringing up $1M in profits from that $10M in revenue. Our workforce of lawn guys has unionized, and competition has brought down our rates, so we’re now at a more normal 10% profit margin. The new CEO of “Eric’s Lawns” decides that the best use of funds is to distribute $500k as dividends, keep $300k in the bank, and use another $200k to expand into Brazil.
7. Billy Collects His Dividend
Billy owned 100 shares, remember? Because ELWN has 10M shares and paid out $500k in dividends, each share is entitled to $0.05 dividend. For his 100 shares, Billy gets a check for $5.
Billy invested at the IPO a total of $200, and now Billy is collecting a $5 bill every three months from Eric’s Lawns, Inc. That is a dividend yield of 10%. Awesome!
Billy, being the astute young man that he is, decides that each quarter he’ll reinvest his dividend into more shares of ELWN. This is a “dividend reinvestment plan” or “DRIP.” That $5 each quarter, assuming ELWN still trades for $2/share, buys Billy 2.5 shares a quarter.
The following quarter, Billy now collects $0.05 in dividends for his (now) 102.5 shares, so he’ll get $5.13. This buys Billy 2.5625 shares. This goes on for a year, after which Billy now has 110.38 shares.
8. Eric’s Lawns Raises That Dividend
With business booming, Eric’s Lawns establishes a capital return strategy that includes raising their dividend by 10% per year. So, now, ELWN pays a dividend of $0.055 per share.
Billy keeps collecting the dividend, and keeps reinvesting into more shares. After another year of reinvesting, Billy has 123.03 shares.
9. Ten Years Pass…
Ten years pass from the start of Billy’s investment. Eric has now been pushed out of Eric’s Lawn’s after a human trafficking scandal, and the company decided that exiling the founder was its only recourse. Eric, shamed and despondent, develops an opiate addition and disappears. They say he spends his days pushing that very same first lawnmower around the Canadian Wilderness, although those reports are unconfirmed…
Billy, though, couldn’t be happier. ELWN is still cuttin’ lawns at bargain prices like a crazed lunatic, and has maintained that 10% dividend growth rate, and Billy has kept reinvesting that quarterly dividend, which is now at $0.13/share per quarter. The share price has held steady at $2, and Billy now holds 476.2 shares worth $952.38. Billy’s little $200 investment way back when has grown at 16.9% per year–amazing! How can an investment grow at more than 10% per year when the only growth is a 10% dividend growth? Well, that’s compounding for ya. Read this for more on compounding.
In Real Life
I’m making some easy assumptions here. First, any company that can consistently raise its dividend by 10% per year will probably experience share price increases as well. As such, the value of the shares will rise, but the number of shares purchased each quarter with that dividend will be less. The net return should offset, though.
Apart from the numbers and the business model being different, this concept is exactly how dividend investing works in real life. Take, for instance, McDonalds. In the last three months, the Golden Arches has made about $1,202,000,000 ($1.2B) in profits. They used about two-thirds of that ($815M) and paid it to shareholders as dividends ($0.85/share). They used about one-fourth ($291M) of profits and repurchased 3M shares. The rest (about $100M) was retained or reinvested in the business. Yes, there are a lot of other moving parts, but these are the big considerations. I say again…yes, there are a lot of other moving parts, but these are the big considerations.
McDonalds has increased that $0.85/share dividend 38 years in a row. Recently the raise has been in the 5-9% per year range.
Summing it Up
To best understand dividend growth investing, just know that you’re not buying pieces of paper or lines on a screen. You’re buying little employees that go to work while you sleep, and send you a little paycheck every few months. And, the best part, every year that diligent little employee gets a nice raise.
If you buy $100 of Apple, you’re buying a little iPhone assembly employee that sends you $1.67 every year and gets 11% raises each year. If you buy $100 of General Mills, your little cereal taste tester sends you $3.09 each year with 7% raises. If you buy $100 of of Phillip Morris, you’re buying a little chain-smoking employee that sends you $4.74 a year with 6% raises.
Are the raises or the paychecks guaranteed? Well, no. But, history says they are highly likely. And, maybe the best part, these are very established and safe businesses–so if you suddenly don’t want to be invested any more, just sell your stake and walk away. Your shares might be worth a bit less or a bit more (almost certainly more so long as you stay invested for more than a few years), but you’ll keep those dividends.
Thanks for reading Retire29.