Dividends are an attractive component of a stock that encourage many investors to own a share within a company. Since dividends, in general, are nothing more than regular cash distributions to shareholders by a company, they’re often seen as a steady income stream for investors.
But what exactly makes them such a popular investment choice amongst many investors, and are dividends stock always better than non-dividend stocks? This article is going to clarify why dividend stocks are worth the investment including both the advantages of investing in dividend stocks and why dividends might not always be the best choice.
The Benefits of Dividends
A Steady Income Stream
Most companies pay a regular dividend on a quarterly basis, which means four times a year. If a company is doing well, that dividend is often increased with each payout. As an investor that would mean for you that you are going to receive a consistent income from just being invested in a company. In order to find out how much of a dividend you are going to receive with your investment, you can use the dividend yield, which is a percentage that shows the amount of money that a company pays out to shareholders as a dividend throughout one year.
The dividend yield can be calculated by simply dividing the annual dividend of a stock by the current stock price. For example, as of May 2020, JPMorgan Chase (JPM) has a current dividend payout of $3.50 annually. The stock price of JPM currently sits at around $87 per share. If we divide the dividend of $3.50 by the stock price of $87, we would come up with a dividend yield of approximately 4%.
Note that you aren’t always guaranteed to receive a dividend from a company. A business may decide to cut its dividend payments at any time, if the management thinks that it’s required, for instance, when the business going through heavy financial hardships.
That being said, receiving 4% annually just from dividends doesn’t sound like a bad investment. What you do with that dividend is completely up to you. You could just cash out that money and use it for your own purposes, or you could reinvest those dividends back into the business in order to acquire more shares. This leads us to the next huge benefit of dividends.
Compounding Growth From Reinvesting
As soon as you receive a dividend payment from a company you either have the option to withdraw that dividend as cash or reinvest that money back. The first option enables you to spend your extra income immediately. But the second option will effectively elevate your long-term returns.
Reinvesting dividends instead of cashing out is such a powerful investing approach because of the compounding effect. Compounding is what essentially enables exponential returns and allows investors to build massive wealth over the long term.
In order to understand the power of reinvesting dividends, let’s assume that you own 100 shares of a dividend stock that pays an annual dividend of $10 per share and currently trades at $200.
Let’s say you decide to reinvest all the dividends that you would receive in order to buy more shares of the company. After one year, you would be able to acquire 5 more shares with $1000 in dividends that you’ve received. That would leave you with 105 shares that pay you a dividend of $1150 after the second year. If you would continue to do this, both the number of shares that you own and the dividends you’ll receive would increase exponentially.
In other words, reinvested dividends enhance exponential returns in the long run. Here is a chart of $10.000 in the S&P 500 with and without dividends reinvested. The results speak for themselves.
Source: Hartford Funds
Cushion Against Market Downturns
The dividend yield of stock plays an important role for many investors. Higher yields on dividends usually attract more potential shareholders to invest in a company because of the beneficial aspects that were already mentioned above. But a hidden advantage that every dividend stock can have is the increased dividend yield which they will offer whenever markets start to turn bearish and the stock price falls.
For example, suppose you own one share of stock that is currently trading at $200. The dividend that the stock pays annually is $12 per share, leading to a dividend yield of 6%. Now let’s say that the market suddenly plummets tomorrow and the price of your stock gets hit by negative market sentiment. While the fundamentals of the underlying company haven’t changed much, the stock price fell to $100 per share.
With the premise that the dividend payout of the company didn’t change, the dividend yield would now be at a staggering 12%, resulting in an increased demand for the stock, as investors become more encouraged to buy that company at such an attractive yield. The increased dividend yield would potentially slow down the fall of the stock price and accelerate price recovery.
Can You Lose Money on Dividend Stocks?
Many people may believe that most dividend-paying companies are known to be financially sound and reliable, turning them into “safe investments”. While a lot of major companies that have proven to be financially growing over the past also pay dividends, this certainly doesn’t mean that those companies are guaranteed to perform well in the future.
Within the stock market there simply aren’t any “safe bets”. All investments will always have an underlying risk of losing value underneath them. The same goes for even the strongest dividend stocks, even if current numbers seem as financially sound as one could imagine. The fact that a company pays a consistent and increasing dividend doesn’t prevent that the stock may perform worse in the future.
Why Dividends Aren’t Always Good
Dividends are a part of a company’s earnings that are being paid out to shareholders as a token for their ownership in the company. But there are a lot of major companies that do not pay any dividends at all. A good example of a company that has never paid any dividends in its history is Berkshire Hathaway. The business that is led by legendary investor Warren Buffett, has clearly outperformed the market over the long term.
Source: Business Insider
But why does a company decide to not pay any dividends? The reason is simple. Any dollar that is being paid out as a dividend is automatically a missing dollar that could have been reinvested back into the business in the first place.
Dividend payments are not a necessity but rather just an alternative way of returning profits back to investors. If a company sees a smarter solution to allocate its capital (for instance, to fund further expansion or conduct share repurchases) than it might as well do so. This would potentially result in a greater return for the investor in the long run.
The reason for Warren Buffett to not pay any dividends was because he knew that the money could be spent more efficiently within the business. He proved that by growing Berkshire Hathaway to such a huge conglomerate that it is today.
To conclude, the dividend aspect of a stock doesn’t necessarily make it a good investment. Whether a company is paying dividends or not rather shows how the business manages its money. The intention for a company to pay a great dividend might solely be to attract more investors even if that money could have been spent for better purposes, resulting in potentially poor growth prospects.
On the other hand, fast-growing businesses might choose to reinvest all capital that is possibly available to fund further growth, which would turn out to be the better decision for both the business and its shareholders.
In the end, it all comes down to your personal preferences. Do you prefer to receive a steady and passive income stream, or would you rather have steadily growing stocks over the long run to profit massively from capital gains?
Either way, you should understand that solely making investment decisions based on dividends might not be a good investment approach, but rather analyzing other different aspects such as the financial health, long-term prospects and the value of the business would contribute to better decision-making and therefore better long term success.