Dividends: Getting Paid To Invest
The nature of investing often involves playing the long game. But what about those companies who pay you dividends while you wait?
For many investors, the joy of owning shares revolves around watching a company (and therefore a stock price) grow over time.
However, that’s not the only way you can profit from share ownership. Certain companies also choose to reward their shareholders by paying them a regular cash bonus called a dividend.
Not all companies do this, and it’s important to understand why so you can better decide where your investment dollars go.
Why Pay Dividends?
When a company becomes profitable it has three choices on what to do with the money:
- Reinvest that money in the business.
- Build up a cash reserve for a rainy day.
- Pay that money back to the shareholders in the form of dividends.
So why would you choose to invest in a company like Facebook that pays no dividends, as opposed to a company like Coca-Cola that pays regular dividends?
That really comes down to what you expect to get out of your investment.
Returns -vs- Reinvestment
Despite having billions of dollars in cash, Facebook has decided not to pay a dividend to its shareholders. They believe the money is better used growing the company. That includes improving the product, hiring the best developers, and acquiring other businesses like Instagram and Whatsapp.
So if you bought Facebook shares two years ago, you won’t have been paid out any cash, but your original investment will have increased about 75%.
That’s a pretty good return.
On the other hand, Coca-Cola has decided to take some of their billions and pay it back to their shareholders in the form of dividends.
Coca-Cola’s management pays out a 3% dividend, which means that for every dollar you have invested, you’ll be paid 3% a year in cash.
That may sound like a great deal, but keep in mind that Coca-Cola’s stock has only risen 8% in the last two years, as opposed to Facebook’s impressive gains.
So there’s a tradeoff there.
Coke’s dividends are pretty reliable – they’ve been paying them out consistently for years. Facebook is still a relatively young company on the other hand, and those investments could have been a disaster and lost shareholders money.
In hindsight, Facebook has been the better investment, but it came with more risk than an investment in Coke.
What Companies Pay Dividends?
In general, high-growth companies tend to reinvest their profits, while more mature companies are more likely to pay out dividends.
You’ll usually find tech companies – with their constant need to innovate – avoid dividends in favour of acquiring new technologies, while energy companies, utilities, banks and healthcare firms tend to favour dividends.
Companies who pay dividends are also those who are less likely to get involved in diworsification, which is always a good sign.
When researching a company, you’ll find a column called “Div & Yield” in the basic information section. This will usually be followed by a number and percentage in brackets.
This number is the dollar amount that is paid every year per share. The number in brackets is the percentage of the current share price that dollar amount represents.
What Should I Expect From Dividends?
The typical company pays between 2-3% in dividends every year. So if you’re just starting out, don’t expect dividends to fund a more exuberant lifestyle or let you quit your day job.
In fact, unless you’re starting out with a big cash pile, dividends will probably have little effect on your overall finances. Younger investors should consider reinvesting any dividends they receive to build up their portfolio.
For older investors or retirees, dividends can provide a steady source of income to subsidize their pensions.
Sometimes you’ll see companies offer a far higher dividend than the average. These companies should be approached with caution as it is often a signal that they are in trouble and are trying to pump up their stock price.
When shopping for dividend stocks, look for companies that have a long history of paying and even increasing their dividend over many years.
Should I Buy Dividend Stocks?
That’s really a personal choice and will depend on a number of factors, including your risk tolerance and your age.
Older investors tend to lean towards dividend stocks because they are traditionally less risky and provide that extra income for their retirement years.
Younger investors have a great advantage in that they can afford to take a little bit more risk and focus on those growth companies that could multiply many times over the years.
Like everything in investing though, balance is key.
Regardless of age, a balanced portfolio should include some large cap bedrock companies to ensure that an economic downturn doesn’t wipe out your portfolio.
The Downside of Dividends
Dividends aren’t always a good thing.
Remember when a company is paying out dividends to you, that’s money that isn’t being reinvested in the company. That’s a company that you own. Perhaps giving that cash to you and your fellow shareholders is not the best use of it.
Berkshire Hathaway is what you would think is a typical dividend company. It’s been around for decades and has interests in energy, insurance, utilities, railroads – all the old dividend sectors.
But CEO Warren Buffett has never (and will never) pay a dividend to his Berkshire Hathaway shareholders. He reasons that he is one of the best capital allocators of all time, and that it would be wasting money to hand it over to people who are less skilled than he is.
And he’s been proven right.
Since the 80s, Berkshire stock is up over 82,000%, and many people have been made millionaires just by holding onto it.
So while dividends can often be seen as a good way to get regular return on your investments, they are mostly offered by companies less likely to experience rapid growth.
And if holding off on dividends is good enough for Warren Buffett, it’s good enough for us!
Note: The author of this article is Rory Carron, Stock Analyst, Rubicoin – Head over to Rubicoin.com to visit the site or download their stock investing app: Learn.
Category: Dividend Stocks
