Markets Explained

Sharing the Wealth: A Primer on Dividends

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Sharing the Wealth: A Primer on Dividends

Let’s be honest: while we celebrate capital markets for their role in powering the engine of American prosperity, most investors don’t invest simply out of love for the free enterprise system. They invest their hard-earned money because they hope to see a positive return on their investment and to build long-term wealth.

That’s why many investors look to stock dividends as part of an overall strategy for portfolio growth. Dividend payments can be beneficial both for investors and the companies they invest in. Let’s take a closer look at the ins and outs of dividend paying stocks and their value in an investment portfolio.

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What’s a dividend and how do they work?

Dividends are distributions of earnings that a company pays to its shareholders. Most dividend payments occur on a regular schedule and distributions often coincide with quarterly earnings announcements. That is, it’s the payment a shareholder receives as a partial owner of the company. Decisions about dividends—to pay them or not, when to pay them, how large they should be—are made by a company’s board of directors.

A shareholder’s dividend payment is allocated on a per share basis. For example, General Electric (GE) announced in December 2014 that its quarterly dividend for 2015 would rise to 23 cents per share. So if you owned 1,000 shares of GE stock, you could expect a $230 dividend payment for the quarter. If GE maintained that dividend payment for each quarter of the year, a stock holder would receive a total of $920 for the year.

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What kinds of companies pay dividends?

Companies that pay out dividends are typically those with a large market capitalization that are more mature and stable, and frequently have less volatile earnings. Since a more established company is less likely to experience rapid appreciation in the price of its stock, paying dividends out of steady earnings can be an incentive for people who want to invest in a stable concern and generate income through their portfolio.

Not all companies pay out a dividend to shareholders. For example, many smaller, younger firms often prefer to plow their earnings back into the company to support operations and set the stage for future growth. Their shareholders are likely to understand the need for reinvesting earnings for the future, and are willing to forego regular dividend payments in hopes that the company’s future will bring steeper appreciation in the stock price.

Many of these younger companies, if they survive, will reach a stage where they continue to boast strong earnings, but their future growth curve flattens out, and they may then elect to pay dividends to investors. That was the case with Microsoft in 2003, when the company announced its first dividend payment after nearly three decades of high-flying growth.

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What are the benefits of dividends?

Investors like dividends for a variety of reasons. Obviously, they can be valuable as a reliable stream of of current income for many investors. That stability may be particularly attractive during a turbulent market cycle.

Investors will look for dividend-paying companies that look to have the potential for long-term earnings growth and a willingness to increase dividends over time. And while dividend income is taxable, qualified dividends are currently taxed at a lower rate than many other forms income, which is also attractive to investors.

Dividends play a critical, if often underappreciated, role in driving portfolio growth and creating wealth. Many investors chose to reinvest their dividends in more of a company’s stock, adding the potential for further growth to their portfolio.

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Are their risks associated with dividend investing?

Investors should always recognize that all investment strategies, regardless of how conservative, entail some measure of risk. Dividend-paying stocks are no exception.

While dividend payments can be a reliable source of regular income, they may not always be the best way to achieve portfolio growth. Particularly during a bull market, when rising stock valuations for younger, expanding firms generate more rapid increases in stock prices, investors may find that investing in dividend stocks achieves comparatively lower returns.

And it’s important to note that dividends are not guaranteed, even with companies that have paid them out for decades. A company can cut or even cancel its dividend payments for any number of reasons, such as financial loss, eliminating debt or the need to reinvest earnings for the sake of future growth.

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How do dividends contribute to wealth formation?

In the fairly recent past, dividends might have seemed a little “boring” – say, when investors were chasing astronomical returns in the tech stock run-up of the 1990s. Then, investing in dividend stocks might have left some investors feeling like they were falling behind.

But over a longer investment term, dividends can play a critical role in growing a portfolio, particularly if they’re reinvested. For example, an analysis by Prudential Investments found that dividend income accounted for roughly 40 percent of the total return on equities in the S&P 500 since the 1930s.

Of course, there’s no one-size-fits all formula for investing. Depending upon their tolerance for risk, age, portfolio size and other factors, many investors may prefer the greater potential upside of buying growth stocks (while recognizing that those same stocks may also have a greater potential downside). Investors who are looking for a multi-pronged investment strategy that may maximize growth and income potential should learn more or talk to an investment advisor to find out if dividend investing is right for them.