What is a dividend, and is it worth investing in dividend stocks?
Let’s walk through the definition of dividend, and compare investing in dividend stocks to
investing in growth stocks.
A dividend is a payment made by a corporation to its shareholders, usually in cash, and
usually as a distribution of profits.
What does “usually in cash” mean?
Well, some companies offer the option to choose a “stock dividend” (you receive extra
shares of the company, rather than a cash payment).
And there can also be a difference in frequency of dividend payments.
Some companies pay dividend annually, others twice per year, and many even quarterly.
What does “usually as a distribution of profits” mean?
Most companies define and communicate a range for a metric called the dividend payout ratio,
which is dividends as % of actual or expected net income.
The dividend payout ratio varies by company, by industry, and is very dependent on the
stage of the business cycle that a company is in.
For mature industrial companies, you can expect an average dividend payout ratio of 30 to
40%, while real estate companies might go as high as 90%.
A lot of companies that are paying a dividend, tend to maintain or raise their dividend over
the years, as lowering dividend might be seen as a sign of weakness.
Therefore, many companies maintain or grow their dividend even if profits are temporarily
lower, or even when they make a loss.
They might be doing this by eating into their cash balance or selling assets.
How does investing in dividend stocks work?
Let’s look at investing in the stock market in general.
Let’s say that Sara wants to make her first investment in the stock market, and become
a shareholder of a company.
She is hoping that the investment she makes today of the small bag of money will grow
into a larger bag of money.
The difference between the current small bag and the expected bigger bag in the future
is called the return.
There are two ways this could happen: by an increase in the share price (Sara might be
able to sell the shares she bought for a higher price than she bought them for) or from dividends
paid by the company.
Depending on the country that Sara is in, there might be a capital gains tax on the
share price increase, and/or a dividend tax on dividends received.
Should Sara invest in dividend stocks or growth stocks?
This is confusing to her.
She doesn’t fully understand what the difference is between dividend stocks and growth stocks.
She does some research online, and finds the profile of a typical dividend stock (company
A): over the past five years, the share price has gone up and down a little, but mostly
stayed in the same range.
That does not look very exciting to her at first.
However, the cash dividend that this company pays on an annualized basis is $2.36 per share.
So if Sara had invested in this company five years ago, she would have made an annual dividend
yield of around 4.8%.
By contrast, a growth stock that she discovers (company B) has had a very significant increase
in the share price, but this company is not paying a dividend.
If Sara had invested in this company five years ago, the value of her shares would have
gone up, but she would have had to sell some of the shares
in order to convert that to cash.
Sara does realize that historical returns (either for dividend stocks or for growth
stocks) are no guarantees for the future performance, and that by investing in the stock market
she does risk losing money if share prices drop.
Sara reviews some presentations by both companies to investors, and finds very different messages.
The dividend stock company says “We have strong cash flow from our operations and disciplined
capital allocation”, while the growth stock company says “We invest every penny in growth:
research and development, capital expenditures, acquisitions”.
Their priorities are different.
For the dividend stock company, returning cash to shareholders is the top priority,
while for the growth stock company maximum investing for growth is the top priority.
Company A and company B seem to have very different opinions on dividends.
The CFO of company A might say “paying dividends is a sign of strength, it shows that we can
afford it”, while the CFO of company B might say “we would only pay dividends if we ran
out of ideas to grow faster”.
Company A wants to be known as stable and dependable, company B as growing and exciting.
Two very different value propositions!
Sara now has a better understanding of the dynamics of investing in stocks, and like
so many others, she decides to mix her portfolio between dividend stocks and growth stocks.
I hope you enjoyed this explanation of the meaning of dividend, and the difference between
investing in dividend stocks versus growth stocks.
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