The meaning of doing business is to make profits. Owning stocks of a prosperous business allows you to receive a portion of retained earnings. Dividends are part of the after-tax retained earnings of an enterprise paid to shareholders.
During the periods of the initial rapid growth of the company, the board of directors practically does not pay dividends, preferring to reinvest all retained earnings into the growth of the company, increasing production and sales. Shareholders of the company support this strategy, believing that in the future it will bring bonuses in the form of rising stock prices and generous dividend payments.
The decision to pay dividends is made when there is no effective way to reinvest retained earnings into further growth to increase the intrinsic value of the company and the price of stocks. This happens when the rapid growth phase has passed, the company has already settled on the market and has become moderately or slowly growing. In this case, part of the income is paid to shareholders, who can find a better use of money.
Why do investors prefer dividends?
Dividend stocks have several advantages, so investors pick them into their investment portfolios:
- Companies that have cash pay dividends. With the help of accounting tricks, you can overstate accounting profits and understate debts. It is almost impossible to manipulate cash, so if the cash is there, the company can pay dividends;
- The dividend yield of a company’s stock may serve as a signal for its undervaluation or overvaluation. Stocks are likely to be undervalued if dividend yield is high and overvalued if low;
- Good profitable companies have a long dividend payment history. Many of them pay dividends continuously for 25 years or more. For example, Coca-Cola pays annually increasing dividends for 55 years and there is no doubt about its reliability and quality;
- During crises and market crashes, dividend stocks on average fall less than stocks of companies that do not pay dividends. In addition, dividend stocks recover faster after a fall when a bull market sets in. This is shown by multiple historical market research;
- It is possible to live on dividends here and now, without waiting for accumulation of big capital due to the sale of stocks that have grown in price. Dividends can be a good addition to salary or pension;
- In many countries, the tax rate on dividends is lower than the income tax. There are also various amendments allowing in some cases not to pay tax at all.
Dividend yield investors
Dividend yield investors buy shares with high dividend yields. Usually, well-established, moderately and slowly growing large companies, the so-called “blue chips”, fall under these criteria. These companies have long gone through periods of rapid development and conquest of markets, consistently earning profits and paying part of them in the form of dividends.
The reliability used is the ratio of dividends to net income or free cash flow. The lower it is, the safer it is, because a smaller portion of income is spent on paying dividends. The remaining profit can be used to update or increase production, repay debts, or invested in liquid securities.
Dividend growth investors
Dividend growth investors are buying stocks with high dividend growth rate per share. For example, the first company with a dividend yield of 1.5%, and the second – with a yield of 3.5%. As the first company grows faster, investors expect that dividends will also grow rapidly, which will eventually lead to high dividend yields.
On a time horizon of 10 years or more, the investor of the first company may receive more dividends in total than the investor of the second company. Despite the fact that the initial dividend yield of the first company was lower.
Important dividend dates
When announcing an intention to pay dividends, the board of directors also announces the ex-dividend date and payment date:
- Ex-dividend date or closing date of the registry – the date on which the list of shareholders of the company will be updated and recorded. On the payment date, only those shareholders who are on this list on the ex-dividend date will receive dividends. If you buy stocks on the day after the ex-dividend date, you will not be able to receive dividends and will have to wait for the next payment date;
- Payment date – the date when the company actually pays dividends to shareholders. Paid dividends are received on a brokerage account, bank account or come by mail in the form of a paper check.
Dividends paid by the company can be reinvested by buying more shares on them. Some brokerage firms can do this automatically. You can also subscribe to the dividend reinvestment program (DRIP).
With the help of the DRIP program, private and institutional investors can spend dividends on buying additional stocks from the company itself, bypassing intermediaries in the form of an exchange and a broker. The advantages of DRIP in the absence of commission and exchange fees, as well as the share price may be lower than the market, reaching 10% discount.
Companies do not always pay dividends in cash. Often dividends are paid in the form of stocks. Many companies have stocks that are not distributed among owners and are not traded on stock markets. Why should these stocks not be used as payment instead of cash?
Stocks are paid based on a certain ratio, tied to the number of stocks from the investor. For example, at a 5% ratio, the investor will receive 5 stocks if he has a package of 100 stocks.
This form is suitable for shareholders who want to have more stocks of this company, instead of receiving cash. In addition, the form allows you to avoid taxes, because the tax is charged only from cash payments.