Creating a Dividend Paycheque
We’re continuing our series called “A Girl Needs Cash.” In our previous articles, we reviewed employer pensions, government benefits and retirement investment accounts. In this article, we’ll talk about how to create streams of income from investments that pay you dividends. It’s like creating an ongoing pay cheque for yourself.
What’s Inside?
Prefer to Listen?Here’s the podcast episode!
Rather Read All About It?This is part three of a four part series. You’ll find the links to the entire series at the bottom of the article.
How did I get into investing?
Let’s start by talking about investing in stocks and how it all works. I have been asked: “How did I get into the field of investment advising?”
I chose to obtain a bachelor of science degree in investing because I’ve always been inspired by the concept of starting a business from scratch with an idea that will help make people’s lives better, growing the business and then ultimately issuing shares of stock so other people can invest in your business and make money from it. That’s always inspired me.
How are Stocks Created?
I think many of us are confused, though, about how stocks are created. It can seem like a big gambling casino. So, let’s run through a story to help illustrate what stocks really are and how you can make money investing in stocks.
Have you ever watched the TV show “Dragon’s Den,” or its US counterpart, “Shark Tank?” On that show, entrepreneurs pitch their business ideas to a panel of successful business people. The idea is that the entrepreneurs want to grow their business and they can do that faster if they can engage the expertise of these panel members.
In exchange for helping the entrepreneurs build their business, the panel members get something in return. One of the things the panel members can receive in exchange is a percentage of ownership of the company.
A company, even in its early stages, has worth. It has the value of all the widgets it sells, all the raw materials and it also has the value of its potential future revenues.
Let’s say we have an entrepreneur named Susie. Susie has a great business that she has grown for a few years selling vegan handbags. It’s called Better Bags. Now she wants to grow it faster by having a factory start producing them rather than sewing them herself. But she doesn’t have any connections and she doesn’t have the money she’ll need to buy all the materials she needs. So she goes on Dragon’s Den and one of the dragons agrees to help her produce the bags. In exchange, the Dragon receives a 20% ownership in the company.
More time passes. Now, Susie’s business is really taking off. She’s starting to earn $100 million in revenue and their brand is recognized everywhere. Susie has become a media darling. Both she and the Dragon she brought into the business with her are making money. They decide they want to really grow the business and expand across several countries. To do this, they need more money, a lot of money. So, they decide to sell stock to the public. This is called an Initial Public Offering or IPO. When they do that, they will go from being a private company--one owned by Susie and the Dragon--to a public company, one that anyone can buy a piece of.
So, how do they do that? Do they just print off a bunch of paper, head over to a street corner and say, “Wanna buy a piece of my company?” No, what they do is hire an investment bank. In the States, that would be an institution like Goldman Sachs. In Canada, our large banks have investment banking divisions. The investment bank looks at Better Bags and says, “Here’s what we believe the value of your company to be and here’s the price at which we think we can sell the stock to the public.”
Then, the investment bank hits the road. Literally, they head out on what’s called a ‘road show.’ This is where they go out to big institutional investors who have deep pockets, like large banks and pension fund managers. And, they say, “I’ve got this great company called Better Bags. They’re thinking about going public, how many shares do you want to buy?” One bank says, “Put us down for 150,000 shares” and another says, “We’ll take 100,000 shares,” and so on.
The investment bank then heads back to Susie and the Dragon and says, “We’ve received orders for 4 million shares of your company. We think we can sell them for $50 a share.” Susie and the Dragon say, “Great, go for it.”
The investment bank then helps Susie and the Dragon through all the regulatory hoops they need to go through to turn Better Bags into a public company and the big day arrives, the day they will be “going public.”
So, what actually happens on the morning of the IPO? The money from the big investors–those banks and pension funds that the investment bank got orders from–flows into Better Bags’ bank account. Better Bags receives proceeds of 4 million shares times $50 per share, for a total of $200 million dollars. Not directly from the public, but from those big institutions who bought the shares through the investment bank. Susie and the Dragon scoop up their money, head over to the office, open a bottle of Prosecco and start planning their company expansion.
They’re done. That’s all the money they will get out of this process.
Back at the stock exchange, though, the fun is just beginning. The big investors who bought shares from the investment bank start selling their shares of Better Bags at the public exchange. Their hope is that the stock price goes up and those big banks and pension funds will make money when they sell the shares they’re holding to the general public. They don’t have any intention of keeping the shares, they want to sell them quickly for a profit.
All this trading that occurs on the stock market after the IPO is between investors; Better Bags does not get any of that money directly. The day of the IPO, when the money from big investors hits the Better Bags company bank account, that is the only cash Better Bags gets from the IPO. After that day, the stock continues to be bought and sold between investors like you and me at a price that investors like you and I determine is a fair price.
And that is how the stock market works.
How Can I Profit from Stock Market Action?
Now, how can you profit from this? How can you make a stream of retirement income from this?
Buy Low, Sell High
One way is by buying those open market stocks, holding them for a period of time and then cashing them in at a higher price than what you paid for them. It’s the same thing as buying and selling your house. It’s an open market. Time is on your side in most cases and you buy at a low price, wait and sell at a high price.
Dividend Payments
A second way is by owning stock shares that pay dividends. What does that mean?
Let’s go back to Susie and the Dragon. They just received $200 million when they took their company public. They used that money to expand the business. Years pass and Better Bags is doing very well. They might want to expand their company later and when they do, they’ll want to raise more money by issuing stock like they just did. They want to make sure that their stock is desirable to the market in case they need to sell more of it. So, they decide to keep their current shareholders happy by offering dividends. Dividends are simply cash profits of a company. If they decide they’re going to give $1.00 for one share of stock to every shareholder, and they have 4 million shares that they sold last time, that means Susie and the Dragon will fork out $4 million to keep their shareholders happy.
That means if I own 100 shares of their stock, they will pay me $100 that year, because they’ve decided to give out $1.00 per one share in this case. The great thing about that is, they’re sending me money and I didn’t have to sell the stock to get it. I can continue to hang onto the stock and hope it appreciates in value before I decide to sell it. And that is the beauty of dividends. You receive money for a stock you own and you don’t have to get rid of the stock to get that money. Your investment makes money while you sleep.
What are Stock Funds?
The problem with buying individual stocks, though, is it takes a lot of time to research and stay on top of. Each of the stocks pays dividends at a different time, usually quarterly, so if you want to receive monthly payments, you will have to find stocks that don’t pay at the same time. They also pay different amounts. What I prefer to do, what I find much easier to manage is to purchase what’s called an Exchange Traded Fund. That is a basket of stocks that you can invest in for a bargain price compared to what it would cost you if you owned each individual stock. That basket itself is traded on the stock exchange and you can purchase it for the market price.
Here’s an example. Let’s say Jane wants to create a stream of $500 a month in dividend income for herself. She sees that Royal Bank of Canada stock paid $4.32 last year in dividends per share. One share of RBC stock costs about $127 right now, so in order for her to receive $500 a month in dividends from owning this stock, she’ll have to buy 1400 shares. That’s about $177,000 if each share costs $127.
Or, she could go out and buy a basket of stocks that are held in an Exchange Traded Fund, such as the Vanguard Canadian High Dividend Yield Index ETF. That fund paid $1.50 in the year 2020 in dividends per share.
You might say, “That’s less than the $4 a share RBC was paying me.” Yes, but the price of this Exchange Traded Fund is only $40 right now. Not $127 like RBC stock. So, in order to earn $500 a month, Jane will need to buy 4000 shares at $40, so she’ll be spending $162,000 instead of $177,000. And, she now owns a basket of stocks, that right now includes stocks from five Canadian banks, not just one. Plus a few other companies.
Quick disclaimer here: Past performance may not be indicative of future results and dividends are not guaranteed. Every year, the company behind the stock decides if and how much it will distribute to you, its shareholders, in the way of dividends. That’s another reason, I think, to invest in a basket of stocks, an exchange traded fund, rather than one single stock. You’re hedging your bets.
But, the choice is yours, you can research and purchase individual stocks yourself or use the one-stop shop method of purchasing a basket of stocks through an Exchange Traded Fund. Either way, you’re creating a dividend pay cheque for yourself, making your money work for you while you sleep, without having to sell your original investment.
So that’s it - Dividends and stocks in a nutshell. Check out the rest of the “A Girl Needs Cash Series” below.
You Will Also Love …
