What Is a Dividend?

by Neal Frankle, CFP ®

When companies make profits they either reinvest that money or pay some of it out to the owners (shareholders).  A dividend is just a cash payment to people who own shares in companies. If you own mutual funds that own shares that pay dividends, the fund holds on to those dividends as they come in from the various companies they hold shares in and usually pays the dividends out towards the end of the year.

In most cases, preferred shares pay the highest dividends. Master Limited Partnerships often pay quite a bit too. But not every company pays dividends. That doesn’t necessarily mean that owning shares in companies that do pay dividends is a better investment. Basically, every profitable company has a decision to make as I said above.  They can either take those profits and reinvest in the company, or they can pay the profits out to the people who own shares. Some people like getting those dividends, but it might be short-sighted.

Neal’s Notes:   Some people love stocks that pay high dividends and that’s fine.  But don’t make the mistake of thinking that dividends are the only (or the best) way to get income out of stocks.

If you own a company that is very profitable, you might prefer that it take those profits and reinvest them in itself. Here’s why. Say you own what is a dividendshares in a technology stock that is able to return 20% on every dollar it has. Well, you would rather your tech company take those dollars and invest and earn that 20% as opposed to paying you those dividends. That’s because you aren’t able to earn as much as they are. By reinvesting those profits, the value of the company will grow and so will the value of your shares.

Does that mean that every company that pays out dividends is a bad investment?

Not at all. Some companies have decided that the best way to provide a good return to investors is to pay out dividends and to increase those dividends every year. There are many reasons for this.

First, some investors simply want the income. People looking for retirement income investments love these babies especially. If one company has a long history of paying out dividends and increasing the payout each quarter or year, that can be a very attractive story. As a result, investors will bid the price for the shares up. If that happens, the owners get cash dividends plus an increase in the value of their shares. Sweet.

Is there something I should watch out for when I look for dividend-paying stocks?

There is a lot to watch out for. First, you want to make sure the company is paying those dividends from ongoing profits rather than from cash reserves. Read the financial statements and the shareholder letters. If the company pays out higher dividends each quarter, they better be making more profits each quarter to pay for it. If, on the other hand, the company is paying out those juicy dividends from cash reserves or from selling off assets, that can be a very dangerous omen. This indicates the company is shrinking and possibly playing tricks. They are trying to keep up the appearance of doing well by paying you higher dividends each quarter. But if the money to pay those dividends comes from anything other than profits, it could be a huge red flag.

Also, high dividend stock prices suffer when the dividend gets interrupted. Every company has its ups and downs. But if a firm is unable to meet share holder expectations, they usually get punished by people dumping the shares and reducing the value. Also, if a company has a very high dividend, the share price could get creamed if interest rates go up. Just as bond prices go down when interest rates go up, the same thing could happen to high-paying dividend stocks.

Finally, remember that a dividend is not an obligation. The company doesn’t have to pay dividends. Bond holders get interest and the company has to pay that interest or face default. But if a company decides not to pay the dividend, shareholders have no recourse.

Are dividend-paying stocks for you?

When you start investing, you should know that there are many ways to generate income from your investments. And if you are retired, you don’t need to have dividend-paying stocks to generate retirement income. You can generate income from growth stocks (or funds as well). That being said, I do not believe that dividends should be your primary concern when selecting investments.

How do you come down on this argument? Are you pro or con dividends?



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{ 2 comments… read them below or add one }

MoneyCone February 11, 2011 at 11:43 AM

Paying dividends used to be the norm for profitable companies! The dot com boom changed everything!


krantcents February 10, 2011 at 9:45 AM

I don’t think it is a pro or con issue. I believe that dividend paying stocks have their place. Certainly a good source of income. Generally speaking dividend paying stocks are not high growth stocks. A portion of m portfolio is in dividend paying mutual funds, but not all of my investments.


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