EPISODE SUMMARY

HOW DO SHAREHOLDERS RECEIVE COMPANY PROFITS?

Shareholders own businesses. Therefore the shareholders are entitled to those profits. But how do I, as a shareholder in Apple (as an example), receive payments when an iPhone is sold? The answer: the profit from Apple, or any other business, is paid back to you as a dividend or retained earnings.

A dividend is simply a part of the profit paid from Apple’s account to your personal bank account as a shareholder. For US companies you would typically receive dividends quarterly, while in Europe, dividends are typically paid annually. Before you rush out and make a firesale of your European stocks, just remember, the total dividend payment for the year would be the same!

Preston Pysh 1:14
All right! So for today’s episode, we’ve got two segments for the show. And for anybody who’s joining us from the previous show, welcome back! We’re excited to have you. I bet if you’re joining us for the first time, and you’re starting out with the second episode, we highly recommend that you go back and listen to the first episode because there was some important information that you need to know in order to kind of continue on into this episode. So in this show, we’ve got two segments. In the first segment, we’re going to continue this discussion that we had pertaining to the profit of the business. Profit is also another term for net income or earnings. And what we’re going to talk about in this episode is how do you get those earnings into your pocket? It’s really nice to be able to say that those earnings are yours and everything, but it really doesn’t make sense until people understand how does that money get into my pocket. So that’s what we’re gonna be talking about in the first segment. And then in the second segment, we’re going to be talking about a character called Mr. Market, which was a fictitious character that Benjamin Graham, who was Warren Buffett’s professor at Columbia. That was a character that Benjamin Graham had come up with for his classroom at Columbia, so we’ll be discussing that in our second segment. So let’s go ahead, and just move into this first segment, and let’s talk about how a shareholder receives their earnings. So this is really quite simple. A shareholder receives the earnings of the business through two different paths. So when we talk about the earnings of a company, let’s say that we’re looking at one share of a business. And in our previous example from the last episode, we said that we had a coffee shop, and then that coffee shop was broken up into 10,000 shares, which meant that one share was potentially worth $10. So if we’re dealing with a $10 share, okay, that you’d buy on the market for 10 bucks. Typically, the profit that’d be associated with that one share would be about a dollar, okay? Ten percent. And if, if a company is able to turn a 10% profit compared to its purchase price, that’s a pretty good price to pay for owning a business. So how would you get, and here’s the question that we’re trying to solve here in this first segment, how would you get that $1 of earnings into your pocket as a shareholder? And how that happens is there are two paths. You can get paid a dividend, which would receive cash or the company could retain that earnings inside of the business itself, which would create more value later on because they could buy assets in a bunch of other things, okay? So we’re going to talk about those two paths in a little bit more depth. So remember $1 of profit, $1 of earnings that are associated with owning that $10 stock. That $1, the first path is through the dividend, okay? So let’s say that this company paid a 30 cent dividend for the year. What would happen is you would have a brokerage account where you own that one share, and then, that 30 cents would be paid straight into that brokerage account as, as just a 30 cent payment. You’d see 30 cents show up for that one share. So if you own ten shares; you own a hundred shares, you just take whatever number of shares you own. You multiply it by that dividend that you receive that 30 cents, and that’s how much money you’d see show up in your account.

Stig Brodersen 4:23
So, very often when you hear that a stock is paying like 30 cents dividend, you need to be aware of whether or not they’re talking about the dividend for a whole year or only for a quarter. In the US, it is so that dividend is typically paid four times a year. In Europe, it’s not (*inaudible*) very often. It’s only one time a year, so you need to be very specific about that when you hear that.

Preston Pysh 4:46
So that’s a great point that Stig brings up. So let’s say we received a 30 cent dividend that’s for the entire year. So if you’re looking at receiving that 30 cent dividend, you would receive that across four quarters of the year. So the first quarter you might receive 7.5 cents. The next quarter, you’d receive another 7.5 cents, and then in totality that would add up to 30 cents for the year. Doesn’t sound like a lot of money, but you got to realize you’re only dealing with a, share that might cost $10, so you got to think proportionally here, and how all this works. So the next question you might be wondering is, “Okay, so I got 30 cents of the dollar profit that I earned as a shareholder, so where did that other 70 cents go? And do I get that or, you know, what happened to it?” And the answer is that that 70 cents is retained by the company, okay? And it sits there in the company accounts, either as a tangible item as cash. It could be really a whole host of different things depending on how the management wants to employ that retained earnings. But for you, in the simplest way that I can describe this is, that 70 cents are retained as your earnings, okay? And as time marches on from this year to the next year, and the year after that. If the company continues to retain these earnings, that’s going to continue to give management more ability to purchase more assets to pay off liabilities, and so that share price should reflect that growth. So, Stig, I saw you had something you wanted to add?

Stig Brodersen 6:23
Yes. So as for you, as a stock investor, you need to see this as a very simple trade-off. If you’re looking at a high dividend, I mean, that’s fine, because then you will receive a lot of money in the short run. But in the long run, there will be less cash retained in the company that the company can grow from. So it’s, there’s really hard to say if you want a high dividend. Well, you might want to have that, but then you are really paying in the long run with perhaps slower growth.

Preston Pysh 6:52
So there’s a, there’s obviously a huge debate on whether you should want a big dividend, or a smaller dividend, or no dividend at all. And it really depends on the person that’s receiving the dividend. So let me just talk through two different scenarios. So, I’m a little bit younger, I’m in my 30s, okay? So I prefer to have no dividend, okay? Because that’s a tax that I have to pay on receiving that dividend. And also the company is taxed before that dividend goes out the door, so when you look at it from an ownership standpoint, I’m kind of being taxed twice by receiving a dividend. The company’s taxed, so whatever that tax is that’s being taken out of my retained earnings that that’s being left over. And then, whenever I receive it as a shareholder, I am being taxed on that money. So that’s something that’s very important to understand. And so, if I’m allowing the company to retain the earnings or I’m basically buying a company that retains earnings, that money has an ability to compound and not get taxed and go through that friction of tax as much as receiving a dividend. Okay, so that’s my opinion. As a younger investor. Now, if you say you’re in your 60s or 70s, and you’re retired at this point, and you’re relying on those dividends to come in to supplement your lifestyle and the way that you’re living, you probably would have a different opinion because you’re using those dividends for a completely different purpose. In one case, the person’s using it to grow their net worth, the other person is using it to sustain their lifestyle. So it really kind of depends on who you are, what you really plan on using these earnings for, depending on how you want to pick the company. Now the other variable to this, so that’s the first variable is, who are you and how do you plan on using the money that this company is making for you. The other variable to this is, “Do I trust the management to make good decisions with the retained earnings?” Okay, so that’s really kind of the other piece of it. So whenever you look at a company like Berkshire Hathaway, they don’t pay any dividends. You have a person like Warren Buffett running the company, and his average return is 20% a year. That’s somebody that you can trust with retained earnings and know that he’s making very good decisions with the money that he keeps within the company. And so, when you go back and you look at the stock price of Berkshire Hathaway, you continue to see Berkshire Hathaway grow at a crazy rate with their share price because that’s being reflected by the retained earnings and what he’s doing with that money that he keeps. If you go to a different company, you might not see the same results. So then you might prefer a dividend over the company retaining those earnings. So, Stig, you had something you wanted to add?

Stig Brodersen 9:32
So Preston, what you’re really saying is that there is no rule of thumb. You aren’t going to say, “I need at least a 20% payout reach or, or 30% payout ratio.” That’s not how you look at dividends.

Preston Pysh 9:45
That’s exactly right! So, you know, everyone’s looking for that, that rule of thumb that it’s, it’s kind of hard sometimes. So with this particular area of interest where you’re talking about, should I receive a dividend? Not receive a dividend? It’s really kind of dependent on those two variables. The first being who are you, and kind of where you at in your life, and what are you using the money for. And then the second variable being, you know, do you trust the management? Has the management made good decisions in the past? And do you expect them to make good decisions in the future? As to how much of a dividend you want to receive, if one at all.

Stig Brodersen 10:20
So, my personal recommendation, if you’re a new shareholder, you might want to pick a company where there is some sort of dividend. And the reason for that is really that if the company is paying out a dividend, it means that they’re making decent cash, and they actually have excess cash. And that is very nice if you’re not completely certain about the company that you’re looking at.

Preston Pysh 10:44
And I, you know, I have to agree with Stig for first-time investors because it’s, it’s really good to kind of see that materialize into your account; to be able to see what your company is doing for you. These, the shares that you’re buying. It’s not like it’s some methodical thing that doesn’t really exist. You’re actually seeing the company make a profit, and then you’re actually seeing some of those profits show up in your bank account. I think that’s a really good thing for first-time investors. So something else that I want to talk about real quick. So it’s a bad thing when you’re receiving a dividend, and that dividend exceeds the profits or the earnings of the company. So let’s, let’s walk through this. So let’s say that your earnings, the profit of the company were $1, okay? And let’s say that you were receiving a dividend of $1 and 20 cents for the year. I think everyone can kind of see there’s a problem with that. That doesn’t make any sense that a company could be paying you a dividend that’s 20% higher than the profits that they made for the year, okay? And believe it or not, that might sound like really, obviously, oh yeah, I’m sure there’s like no companies doing that. But to tell you the truth, there’s a lot of companies that do that. And it’s actually quite surprising when you start looking around the internet, and kind of researching different picks, and you go down and you look Look at the earnings per share, which is, here’s a term here, this is a very important term, E-P-S, okay? That’s earnings per share. And when we said that there was $1 of earnings for that one share that we own, that’s exactly that number. So, if you go on the internet and you look up, a company, call your, let’s just say you’re looking up at Chevron or ExxonMobil or one of those kind of companies. And you go down and you look at the EPS, the earnings per share, that’s the profit per share, okay? So when you look up that number, and it’s much higher than $1, but let’s just say that it’s $1, okay? And you see that, you know that that’s the profit that the company has made for an entire year, okay? That EPS is profit for one year. So, when you see that number, and you compare it to the dividend. Let’s say the dividend for whatever reason was $1 and 20 cents, which it’s not for those two companies that I just named, but you would look at that and say, “How is that company paying me this much cash right into my brokerage account when they’re only making $1 a year?” And that’s a question that, you know, is a very good one and one that should really make you shy away from that company. So, that’s kind of a discussion. I’m sure we could go into a whole lot more. But in general, I think the thing that we got to take away from this first segment is twofold. Okay, your, your profit, your earnings is paid out in two different directions, okay? The first direction is it can be paid out as a dividend. Some companies don’t pay any dividends, okay? If that’s the case, all the money is then retained by the company to purchase new assets, to pay off old debts. And when they do that, the, the equity of the business is going to grow and you’re going to see that reflected in the stock price of, of the business over time, okay? So that’s the two things that we really want you to take away from this. Okay, so let’s move into the second segment where we talk about about Mr. Market, okay? So like I said in the intro, Mr. Market was a fictitious character that Benjamin Graham used for his students at Columbia University whenever he was teaching them. And like I’ve said a couple other times, Benjamin Graham was Warren Buffett’s professor that taught him all these different things that really kind of turned Buffett into the billionaire that he is today. So very important person to discuss when you talk about value investing. So, Mr. market was this fictitious person that would show up at your doorstep. So imagine a salesperson with the suitcase and the, you know, the the suit on, he would show up and he would knock on your door, and when he would arrive, he’d say, “Hey, I’m selling all these different things!” And he’d open up the suitcase and show you what’s inside. And the way Graham described it was that the stuff inside the suitcase were just a bunch of different stock picks, and Mr. Market would come back. Every. Single. Day. And he’d show up, maybe call it, nine o’clock in the morning, he would he would knock on the door. Every single day at nine o’clock, and you’d open up his briefcase, and he’d say, “Hey, I’m selling these things. And these are the prices of these things, TODAY.” And the reason Graham liked this example is because he showed students that Mr. Market is your servant and not your guide, okay? And what he meant by that is this person showing up at your door and offering you these prices, he is there to serve you. You are not to look at what he’s selling, and, and say, “Oh, well, that price is this today. So now I need to be scared or I need to be excited.” Instead, you need to, to look at what he’s bringing you and saying, “You know what? I think that that stock right there, Stock A, is worth $10.” And Mr. Market showed up today and he’s selling it for $15, okay? Well, that’s a lot higher than what I’m willing to pay, so I’m just going to tell Mr. Market to go away, okay? And so then Mr. Market would leave. And then, let’s skip one day in advance, and Mr. Market comes back and he knocks on your door, and you open up the door, he comes in and he opens up the briefcase, and Stock A today, he wants to sell it for $8, okay, which is completely different than the previous day. And so, what Graham is teaching his students with this example is, “Look at what the market is offering you, okay?” Don’t look at the market and saying, “Oh, my god! I should be scared because the price he offered the day before was fifteen, and now he’s offering me eight. And that would scare, and they’re looking at it relatively, instead of looking at it, “What do I think Share A is worth,” and “What is Mr. Market offering me as a servant?” Okay? So that’s the, that’s really what he’s trying to drive home here with this Mr. Market example. So, Stig, go ahead! I see you have something you wanted to add.

Stig Brodersen 16:45
Yeah, guys. So what Preston is really saying that patience is very, very important for you as a stock investor. I think we can do a whole new podcast about what kind of mental skills you need to have to, to be a stock investor. But the great thing to understand about Mr. Market is really that he comes by your office every day. Every Monday to Friday, he drops by your office, and he will give you new quotes everyday. And even on a daily, hourly base. So, patience is really, really important. You don’t have to buy stocks today, not next week, or perhaps not this year. I know that Warren Buffett used to say that if he gets one good idea each year, that is enough to make him wealthy.

Preston Pysh 17:26
So, you know, we could go back to the coffee shop example that we had from the first episode. You know, if, if you were trying to buy a coffee shop in your local town because you thought it was an outstanding business, and you approached the owner, and you said, “Hey, I’d like to buy your coffee shop!” And the owner says, “Well, I want to sell it for $300,000.” And you know, you maybe thought it was worth a $100,000. You’re not going to get all emotional, and say, “Oh, my god! They wants, so much higher. You’re just gonna have to kind of take it as is at face value, and say, “You know what? That’s a little higher than I was willing to pay.” And just kind of walk away from the offer. That doesn’t mean that maybe six months later, you go back to the same person and say, “Hey, I’m still interested in buying your coffee shop. Would you be willing to, to sell it to me for a 100,000?” And then the person says, “Ah, you know, I haven’t had any luck. I’ll sell it to you for a 150,000. Okay, so now it’s a different offer on the table. And maybe you might say, “Yeah! That’s a little higher than I want to pay, but I do want to own it, so I’m gonna buy it at 150, okay?” Same exact thing on the stock market, okay? The same exact thing. And when people start looking at it from that vantage point of, “Hey, this market’s just offering me a different price. That doesn’t mean that the price is right or wrong. You’re the person that’s got to determine that. And that’s really kind of the whole gist of what Benjamin Graham is trying to get at with this Mr. Market example. So, Stig, you had something you wanted to add?

Stig Brodersen 18:53
Yeah. And what’s really great about Mr. Market is that he does not get offended. So for instance, if I walked down to my local coffee shop, and I asked him everyday, “So Sir, can I buy your business?” He will probably get pretty annoyed with me. But Mr. Market is a much more pleasant guy, who would drop by your office again everyday with a new price. That’s actually a huge advantage. You don’t need to spend so much time, so much energy because you get the prices everyday.

Preston Pysh 19:21
Okay, so I think that that kind of concludes the second episode. The, the points that we really want to drive home in the first segment is that when you’re paid this profit, there’s two ways that you can get it through a dividend or retained earnings. And then the second segment we were talking about Mr. Market and how you just need to be a patient investor and wait for the price that you know the company is worth, and then buy it whenever it’s around that price point. Okay, so that concludes our show! And if you guys are enjoying this and really like it, we would really appreciate your support on iTunes. Remember if you go to asktheinvestors.com, and you can ask a question there, you can record your question, and we’ll play it on the air. We’ll send you a free signed copy of the Warren Buffett Accounting book. And we just really in general, just appreciate your support. So we look forward to seeing you in the next episode, and thanks for joining us!

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Extro 22:09
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