Some of the most essential ingredients to any successful, long-term investment strategy are dividend-paying stocks. A portfolio without many (or any) dividend stocks is likely missing out on valuable opportunities, whether that entails a passive income in the form of dividend payments or dividend reinvestment plans (DRIPs), which automatically reinvest dividend payouts back into your portfolio.
Many experienced investors already realize why dividends matter, but newer investors who want to make big returns more quickly could be overlooking the long-term value of dividend-paying stocks by pouring money into rapid-growth, hyped up stocks with no dividends instead.
Don’t make this mistake with your own portfolio. Whether you’ve been casually investing for years or you recently made the plunge into the world of hands-on investment management, it’s incredibly important to understand why dividends matter to investors of all incomes and levels of experience and knowledge:
Importance of Dividends
First and foremost, you might be wondering why dividends are so significant in the first place. While there are plenty of non-dividend stocks with excellent ROIs for their shareholders out there, dividend-paying stocks are unique because you get tangible returns in the form of quarterly (most common) payouts.
This isn’t to say dividend stocks are superior to their non-dividend paying counterparts in every way – there are dividend traps with substantial risks for investors, after all – but these types of investments are undoubtedly good signals of a company’s financial stability (and thus, its ability to sustain its operations over a long time frame).
How so? Because dividends play an influential role in how companies decide allocate their profits, whereas publicly traded companies without dividends have greater freedom to heavily compensate their executives and manage their assets in ways that might not always maximize the stock value for shareholders. These problems are more easily avoided with dividend-paying stocks because companies have greater obligations to either maintain or increase dividend payouts to their shareholders, and thus, they are more efficient when it comes to capital management.
Why Do Companies Increase Dividends?
If dividends force companies to listen and acquiesce to shareholders more frequently, then why would they willingly burden themselves with a practice like paying out dividends on their stocks? For one, dividends tend to attract investors without putting too much pressure on the company to grow (this is why companies in rapid growth mode tend to avoid paying dividends on their stocks – so they can keep more cash on hand for expanding business operations).
Additionally, dividend growth is a publicly visible indicator of a company’s good health; if cash hoards were running low then a company would not be able to afford dividend payments 4 times per year and would likely cut the dividend. Thus, the dividend growth rate is a critically important indicator of a company’s stability – which is something every investor should pay attention to.
Grow Your Wealth with Dividends
A recent study on the average returns for stocks between 1991 and 2015 found that non-dividend stocks earned a measly +4.18% average annual return, while dividend-paying stocks earned an average of +9.7% each year. This fact alone should encourage more investors to flock to dividend stocks, but there are plenty of other reasons why dividends matter for long-term financial success, including:
– Consistent returns with the ability to reinvest those returns 4x per year for maximum portfolio growth in a DRIP
– Long-term dividend growth potential for investors who care more about stability and the probability of dividends increasing over time (as opposed to high yields in the status quo but potential instability later on)
Of course, it’s worth noting that investing in dividends is not as easy as picking some stocks with high dividend yields and waiting for huge quarterly payments to roll in. Instead, there are many factors you need to evaluate before choosing the right dividend-paying stocks for your portfolio. These factors include: current vs. historic dividend yield, company’s annual earnings growth vs. dividend annual growth, and the dividend payout ratio (dividends vs. earnings per share).
Final Thoughts on Why Dividends Matter
When it comes to dividend-paying stocks, it should be less of a question about why dividends matter and more of a question about what dividends matter. After all, each dividend-paying stock is different; even those with similar returns (both historically and currently) may be in vastly different places within a few years, depending on their respective companies’ financial health and efficiency of the management.
For everyday investors, dividend stocks offer a clear and stable passive income opportunity, though you may also opt to automatically reinvest those dividends back into the company to maximize your returns over the next several years. The math favors the latter scenario (using DRIPs to compound your returns on investment), but there’s nothing wrong with cashing out each quarter, as long as you research the best dividend stocks for your dividend portfolio before jumping on the bandwagon.
FAQs
The dividend yield measures how much income has been received relative to the share price; a higher yield is more attractive, while a lower yield can make a stock seem less competitive relative to its industry.
Why do dividends matter to investors? ›
Five of the primary reasons why dividends matter for investors include the fact they substantially increase stock investing profits, provide an extra metric for fundamental analysis, reduce overall portfolio risk, offer tax advantages, and help to preserve the purchasing power of capital.
Why is the dividend decision important? ›
Importance of Dividend Decision
The dividend decision defines the cash received by shareholders. Influences share price: The price of shares depends on future cash flows to shareholders, including dividends and capital gains. Dividend policy decisions affect share prices and returns.
Why dividends not really affect the shareholders? ›
2 Dividend irrelevance theory
The rationale behind this theory is that dividends do not affect the cash flows or the risk of a company, and that investors can create their own dividend policy by selling or buying shares. Therefore, the dividend payout ratio has no impact on the share price or the cost of capital.
Why do some investors prefer not to receive dividends? ›
Not all investors consider paying out dividends the best move. Some believe reinvesting profits instead can increase a company's long-term value and deliver more significant shareholder benefits through a higher share price.
How do dividends affect investors? ›
After the declaration of a stock dividend, the stock's price often increases; however, because a stock dividend increases the number of shares outstanding while the value of the company remains stable, it dilutes the book value per common share, and the stock price is reduced accordingly.
What do investors do with dividends? ›
Dividends can have a big impact on your portfolio over time. They can help generate income during retirement or earlier and can also be reinvested to increase your total investment return.
How important are dividend stocks? ›
Dividend investing can be a great investment strategy. Dividend stocks have historically outperformed the S&P 500 with less volatility. That's because dividend stocks provide two sources of return: regular income from dividend payments and capital appreciation of the stock price.
What is the function of a dividend? ›
A dividend is a portion of a company's earnings that is paid to a shareholder. The most common type of dividend is a cash payout, but some companies will issue stock dividends. Dividends are typically issued quarterly but can also be disbursed monthly or annually.
What is the main determination of dividend decision? ›
There are various factors affecting the dividend decisions of firms carefully assessed. Profitability, cash flow, financial health, growth options, industry norms, legal and regulatory needs, and shareholder preferences all play an important role in shaping dividend policies.
Key Takeaways
Dividend irrelevance theory suggests that a company's dividend payments don't add value to a company's stock price. Dividend irrelevance theory also argues that dividends hurt a company since the money would be better reinvested in the company.
Do dividends have to be equal to all shareholders? ›
The dividends that you pay out to shareholders don't have to be for an equal amount, but your shareholders will need to have different classes of shares for this to happen. In this article we explain how dividends can be paid out for unequal amounts.
Do shareholders prefer dividends? ›
Many investors like the steady income associated with dividends, so they will be more likely to buy that company's stock. Investors also see a dividend payment as a sign of a company's strength and a sign that management has positive expectations for future earnings, which again makes the stock more attractive.
What's the highest dividend paying stock? ›
10 Best Dividend Stocks to Buy
- Verizon Communications VZ.
- Johnson & Johnson JNJ.
- Philip Morris International PM.
- Altria Group MO.
- Comcast CMCSA.
- Medtronic MDT.
- Pioneer Natural Resources PXD.
- Duke Energy DUK.
Conclusion. A stock dividend can reward shareholders with additional company shares instead of paying them in cash. The stock dividend does not impact a shareholder's net worth. However, it increases the number of shares in the market, generating additional liquidity for shareholders.
What type of investors prefer dividends? ›
Different investor types tend to have a preference for how excess cash flow is returned. For example, investors who desire supplemental income, such as retirees, often prefer to receive dividends. A dividend is a real cash payment, which the investor can then use to spend however they wish.
Do investors prefer high or low dividend payouts? ›
The Bottom Line. Investors should always prefer healthy payout ratios over high payout ratios. Very high dividend distributions may be attractive in the short term, but they may not last going forward as discussed above. New Dividend Initiators can also be preferred if someone is looking for a hybrid value/income pick.
Why do some investors prefer high dividend paying stocks? ›
In addition to providing consistent income, many dividend-paying stocks are in defensive sectors that can weather economic downturns with reduced volatility. Dividend-paying companies also have substantial amounts of cash, and therefore, are usually strong companies with good prospects for long-term performance.
Why my investors prefer cash dividends over stock dividends? ›
While cash dividends result in immediate cash payments to shareholders, stock dividends increase the number of shares that investors in a company or fund own. Cash dividends may be preferred among income investors, but will require taxes to be paid.
