Part I – Dividend Basics
Sid Roy & Sanjib Saha
22 December 2024
Over the last three sessions of Ask-Learn-Share this year, we talked about Dividend Investing. In this article, we summarize the key points and questions that came up during the discussions. It is one of those topics that most of us think we know, but rather superficially. So, it was very useful to spend some time on this topic and learn. We will take a different approach for this article and use a Q&A style to present the information. For your convenience, we are publishing three separate posts instead of a single long read.
Enjoy!
1. What is a dividend?
We are familiar with the concept of purchasing stocks. Typically, we invest in stocks expecting that their value will increase over time, and we can sell them later to make a profit. Good companies are expected to prosper and consequently, their share prices are expected to rise over time, albeit with short-term fluctuations.
However, many companies regularly dole out cash, aka dividends, to their shareholders. For example, Microsoft paid a dividend of 83 cents per share in December 2024. If you owned 100 shares of Microsoft stock, you would have received 83 dollars as dividend in your financial account where the shares are held. Holders of such dividend-paying stocks thus expect regular income from these periodic dividends.
2. Is dividend from stocks the same as interest from CDs or Bonds?
Though the income stream from stock dividends might look like getting interests from Savings account, Certificates of Deposit or a Bond investment, there are important distinctions. While the interest from a typical Fixed Income investment is contractually guaranteed, stock dividends are not. A company may decide to reduce, suspend or pause such dividends at any time. In other words, income from dividends is much riskier than interest income from typical Fixed Income investments.
Another related distinction between stock dividends and bond interests is about the dividend amount paid. Interest from Fixed Income investments depend on the market interest rate and therefore has much less room to grow over time. Dividend from a company is expected to grow over time as the company prospers and its income per share increases. In other words, despite being riskier, dividend income is expected to catch up with inflation much better than interest income.
Last but not least is the safety of principal. CDs and Bonds are much safer as their principal amount remains constant when held through maturity. However, stock prices fluctuate all the time and investors can lose part or even all of their investments.
3. Why do companies pay dividends?
Historically, companies used to issue dividends so that their shareholders get a tangible return from their stock holdings and perceive these investments worthwhile. Dividends make stock investment attractive and a lucrative, inflation-beating alternative to keeping the investment dollars in Bank accounts or fixed income investments.
A company issues shares to raise capital needed to run and grow the business. In its initial days, any profit made by the company is likely to be used up in growing the business and strengthening the company financials. Companies at this life-stage usually can’t afford to pay dividends. However, once the business becomes established and makes a steady profit, it might have surplus money for which there are no attractive options to reinvest the extra cash into the future growth of the business. This surplus income is often used to pay out as dividends. Dividends are also used to signal good financial health for the company and support the valuation of the company stock.
4. What about companies that don’t pay dividends? Are they bad to invest in?
Not at all. About a third of the US public companies don’t pay dividends, and many of them are great investments. Conversely, a few companies paying out hefty dividends may turn out to be lousy investments.
For example, a company with excellent growth opportunities may decide to reinvest all their profit back to the business through capital investments, or strengthen their balance sheet, or save it for any future opportunities, or a combination of these. The board may decide that there is better use of any available cash than paying dividends. Though the company doesn’t pay dividends, it can still be a great investment.
Similarly, a company may have a genuine need to preserve cash or use their profit to improve the health of the business but still decides to continue paying dividends to avoid sending a wrong signal to shareholders by suspending or reducing the dividends. This company may not be a great long-term investment despite their dividend payouts.