When you buy a share of a company, you become an owner of that company. You are entitled to share the profit the company makes every year—you shared in the risk, and you share in the reward.
How do Dividends Work?
A dividend is a portion of the profit the company makes, which is paid to each shareholder. For example, if Acme Lemonade Stands makes a million dollars in profit and has a million shares, the company could pay a dollar per share as a dividend. The profit of the company belongs to its owners—its shareholders—so they're entitled to that profit somehow.
A dividend is a portion of the profit of the company. The directors of the company look at the financial health of the company and decide whether it's better to pay some of the profit of the company to the shareholders or to do something else with the money.
If you're a shareholder, a dividend is nice because it's money you earn from owning the stock. Think of it like the interest you earn on a money market account or a CD. This is money you earn from stocks without even selling them; remember to calculate this dividend yield in your rate of return.
When Do Stocks Pay Dividends?
The frequency of how often companies pay dividends varies. Good stocks often pay dividends quarterly. It varies by company, but a good company with a regular dividend will pay out every three months, often announcing the dividend with its quarterly earnings. A really good company with a reliable dividend may send you a check every three months just for owning a share of stock.
The company's directors and executives have to consider several criteria when deciding the frequency and amount of dividends. Regular payouts can demonstrate attractive stability. Many investors like reliable dividends because they count on that money every quarter. They know that every share of Acme Lemonade Stands will pay them a dollar per share every year, as long as the business continues to make profits.
The best dividend paying companies increase their payout regularly. That's a sign of true long term success. These are well-established companies, like DJIA stalwarts GE and Coca-Cola. They may not see booming growth of smaller companies because their valuations are so high already, but they continue to make lots of money every year and return it to shareholders.
If your portfolio contains mutual funds or index funds, they're receiving the dividends and calculating the increase for you. Many fund companies like Vanguard have high dividend yield index funds, such as VYM, available.
Why do companies pay dividends? Because profits belong to the owners of the company—the shareholders—and the company doesn't see any better opportunities to invest the money.
What are the Alternatives to Paying Dividends?
Do all stocks pay dividends? No. To pay out, a business must have that money available somehow. Other companies earn very small profits or need the working capital for liquidity purposes, so it doesn't make sense to pay dividends.
Even if the business has the money, it still has a few alternatives.
A company might choose to hoard its profit. This is especially true for businesses with cyclical sales and profits. For example, an airplane manufacturer might spend a lot of money one year building or upgrading a factory. It might lose money that year. In a couple of years, when the factory is making lots of planes and selling lots of planes, profits might go up, and so the company will prefer to save that money to buy the next factory.
Similarly, a company that plans to grow much larger might reinvest its profits back into the company so that it's worth more in the near future. You often see this in technology stocks, where acquiring more customers or increasing the value of each customer will hopefully produce even more revenue in the future—and more profits.
A company might also acquire other companies. This is similar to investing in the company. You can see this happen in very large companies, where it's cheaper and easier to buy an established but smaller company than it is to start a new line of business.
Finally, a company might buy back shares of its stock and retire them, so that every remaining share owns a larger piece of the company and thus becomes more valuable. This strategy makes a lot of sense when the price of the company's stock is artificially low.
Each of these choices has a common theme: the intent to make the company itself intrinsically more valuable, whether by expanding the customer base and product offering, by providing opportunities to enter new markets or capture more of an existing market, or by increasing demand and thus raising the price of the stock itself.
A company which can do this is worth more than gold; a company with a solid business that grows and generates more cash every year is a great company to own. Instead of financing its growth (or even continued operations) through debt, it's free to build up its own equity.
Why Do Some Companies Not Pay Dividends?
A company may not pay a dividend if its directors believe that it's better to put the business's profits to work making the business itself more valuable. Warren Buffett's Berkshire Hathaway does not pay dividends. The company famously grown through acquiring other good businesses, mostly in the US and Canada, many of which themselves do pay dividends. If Buffett and his partner Charlie Munger ever felt that the best use of the company's profits were to return it to shareholders, Berkshire Hathaway would pay a dividend.
An established business with a dominance in the market and few opportunities to grow may not have this luxury. In that case, the value of the stock includes the consistent dividend payout. In other cases, the value of the stock depends on the company growing larger and making steadily more money. These growth stocks often do not pay dividends.
Yet dividend stocks have their risks, too. Yields don't always rise. Profits can be volatile. Payouts can be cyclical. The effect of interest rates on dividend stock prices is complicated. Furthermore, some companies facing difficult times might raise their dividend payouts to appear more attractive. Always check to see what the real cash flow situation is before you chase down the highest dividends.
A stock with a reliable dividend payment with increasing yield is worth considering, but chasing the highest dividend paying stocks is not always the right choice. Plenty of good businesses have great stocks and never pay a single cent to investors. Look for great stocks, not necessarily quarterly checks.
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