Stocks that pay dividends have a long history in the US. Many retirees have lived on the quarterly checks from large companies, while others have plowed the dividends back into the stock to increase their investment. But what is a dividend stock, and is it right for your portfolio?
What is a dividend?
A dividend is a distribution of a portion of a company’s earnings to shareholders on a certain date. This can be in cash or additional stock. In addition to certain stocks paying dividends, funds that own dividend-paying stocks may also pass on a dividend to their investors.
Some companies have long histories of paying dividends and often of increasing their dividends over time to reward their shareholders. This track record may persuade companies to continue making payments even if their earnings and profits suffer. Additionally, a company can make a one-time dividend payment if they’ve had strong performance.
Why some companies pay dividends and others don’t
Larger, well-established companies are most often dividend payers. Frequently, these companies don’t need to reinvest their capital into the business. The decision to start paying dividends sends a clear message to the markets about not only the strength of the company’s financials but its place on the growth curve – it’s no longer having to sustain itself by pouring all available cash back into the business. As part of that, it’s probably not growing as fast as other non-dividend stocks. Utilities, banks, and healthcare companies are often dividend payers.
Smaller companies and fast-growing companies usually will not offer a dividend because they are using available money to grow the business or pay down debt. Some companies build up a cash position so they can make acquisitions, again to help grow their business. Additionally, companies may choose instead to add value to shareholders by repurchasing their stock with available cash rather than starting a regular dividend payment.
Pros
Passive Income. When you own dividend stocks, you will regularly receive a certain amount per share you own. While you are young, this can easily be invested back into the stock to grow your investment over time. When retired, dividend stocks can provide income without you having to sell shares in your investment.
Potential defense against down markets. Not all dividend stocks are stodgy companies, but many experience much less volatility than small caps or high-growth companies. While this may limit gains, it can also limit losses. Yet when the markets are tanking, companies with a long history of paying dividends will be loath to reduce their regular payment. In fact, if the stock price falls and the company still pays a dividend, you can add more shares to your portfolio at a lower price.
Cons
Slower growing companies. A large dividend-paying company has most likely built out the infrastructure needed to maintain their client base and achieve some level of profitability. That’s why they can pay dividends. Once they have reached this level of maturity, many will grow slowly over time while still reaping the rewards of their earlier investments. You might not see the stock price appreciation as with growth firms. A dividend is used to provide an enticement to investors to consider the stock.
Double taxation. When a company is doing well they usually end up paying taxes on their earnings. If they pay a dividend, you also end up paying taxes on the dividend. While you’re still only paying taxes once, the money has been taxed twice. Note that there are ways to reduce your dividend tax rate to a capital gains rate if you hold the stock for a period of time around the ex-dividend date. Research or talk to an advisor for more details.
Dividend cut. Most long-term dividend payers try their hardest to maintain a dividend, even in bad economic times. Yet there are times when it’s more prudent to cut or even stop the dividend payment. There’s no obligation to continue at a certain rate. When the markets tanked during COVID, many companies temporarily dropped their dividend payments until the markets started recovering. In normal times, a reduced or canceled dividend can result in an outsized drop in the stock price as well.
Consider a dividend fund
Dividend stocks can provide steady income and increase your portfolio’s profitability. Be sure to understand how to analyze dividend stocks and research any companies in which you want to invest.
Many people choose to skip the company-by-company research and instead invest in mutual funds or exchange traded funds that hold a broad array of dividend-paying stocks. You can instantly achieve greater diversification versus buying only a handful of stocks.
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