What is a stock dividend and why do you care?
When we buy stocks, we all hope their price will appreciate. Buy stock in a company at $100. Hold that stock. Watch the company’s stock price grow. Sell your shares. Profit. It’s simple! Hopefully in the future, that company will be worth $1,000 or $10,000 per share. Or it will split over and over, give us more shares and grow into the same price or more.
Often, though, we ignore dividends as a fantastic way to grow and distribute wealth. Many companies pay dividends to their shareholders, which represent a distribution of their profits. These dividends are a second avenue of earnings that equities can provide.
Traditionally, dividends are paid by companies that have become “mature” businesses or are in a “mature” industry. That translates to a business or industry that doesn’t have a lot of growth potential. Think petroleum, utilities, banking, etc…. While there is some growth to be had in those industries, it’s usually gained from acquisition more than from industry expansion or company innovation. These companies can’t entice people to invest in their stock for price appreciation, as they typically can’t outgrow companies in more dynamic industries. They have little need to keep their profits and invest them in growing their business. As a result, they are likely to pay a share of those profits directly to their shareholders in the form of dividends.
Let’s look at company XYZ, for a hypothetical. This is an oil and gas pipeline company. Both the company and the industry in general exist in a place of very little growth. Five years ago, its price per share was $50. Today the price is $50. A stock that gains no value in the last 5 years isn’t a very attractive investment, is it? In a stock like this one, we have to focus on the dividend income it generates as much as, or more, than the price of the equity. While it has gone absolutely nowhere in share price value over the last 5 years, the company has paid a dividend over $2 per share annually all five years. That’s 4% annual yield.
If you bought this company’s stock 5 years ago and only paid attention to its price, you’d be very disappointed in what you got for your investment. If you factored in all the dividend payments you have received over that time, however, it becomes a very attractive way to invest money and have regular payments made to you that represent 4% of your investment. It’s hard to find any vehicle that has potential to generate that kind of residual income today.
Owning shares of dividend-focused companies is an excellent strategy for those that want regular cash payments for income. If you wanted income from a portfolio of stocks that didn’t pay dividends, you’d have to constantly sell shares in order to generate your needed cash, even if those shares had dropped in value significantly. Using dividends as a means of generating that cash can prevent the need to sell shares for that income.
Buying shares of dividend-paying companies is not risk-free. Dividends are not guaranteed, so it is imperative to remember that income can fluctuate over time. It’s very important to examine the quality of the company that pays the dividends and their dividend history before investing in it.
Invest in equities with a purpose. Remember, growth companies and dividend-paying companies are not always the same and can be two very different tools. Make sure you have the tools that are right for your plan.
By: Jesse Taylor, CFP®, ChFC
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