The nature of investing involves playing the long game and waiting for your investments to grow. But what about the companies that pay stock dividends while you wait?
For most long-term investors, the joy of owning shares revolves around watching a company (and its share price) grow over time.
However, that’s not the only way you can profit from share ownership. Certain companies also choose to reward their investors by paying them a regular cash bonus called a stock dividend.
Why Pay Dividends?
When a company becomes profitable, it essentially has three choices of what it can do with the money:
1. Reinvest that money in the business.
2. Build up a cash reserve for a rainy day.
3. Pay that money back to the shareholders in the form of dividends.
But why would you choose to invest in a company like Facebook, that pays no dividends, as opposed to a company like Coca-Cola, that pays regular stock dividends?
Well, that all depends on what you want to get out of your investment.
Return -vs- Reinvestment
Despite having billions of dollars in cash, Facebook has decided not to pay dividends to its shareholders. Management believes that the money is better used by helping the company to grow. That includes spending money on improving the product, hiring the best developers, acquiring other businesses like Instagram and WhatsApp, etc.
Look at it this way. If you bought Facebook shares when the company IPO’d, you won’t have received a cent in cash dividends. However, your original investment will have increased more than fourfold.
That’s a pretty good return.
On the other hand, Coca-Cola has decided to take some of their billions and pay it back to their shareholders in the form of dividends. Coca-Cola’s management pays out a 3% dividend—which means that for every dollar you have invested, you’ll be paid 3% a year in cash.
That may sound like a great deal, but keep in mind that Coca-Cola’s stock has only risen 8% in the last two years.
So when we compare Coca-Cola to Facebook, we can see the tradeoff.
Coke’s dividends are pretty reliable—they’ve been paying them out consistently for years. Facebook is still a relatively young company, on the other hand, and needs to constantly reinvest in itself to ensure it continues to grow. Those investments could have been a disaster and lost shareholders money though.
In hindsight, Facebook has been the better investment, but it came with a lot more risk than an investment in Coke.
What Companies Pay Stock Dividends?
In general, high-growth companies tend to reinvest their profits back into development while more mature companies are more likely to pay out dividends.
You’ll usually find that tech companies—with their constant need to innovate—avoid dividends in favor of acquiring new technologies. On the other hand, energy companies, utilities, banks and healthcare firms tend to favor dividends.
Companies who pay dividends are also those who are less likely to get involved in diworsification, which is always a good sign.
When researching a company, you’ll find a column called ‘Div & Yield’ in the basic information section. This will usually be followed by a number and percentage in brackets. This number is the dollar amount that is paid every year per share. The number in brackets is the percentage of the current share price that dollar amount represents.
What Should I Expect From Dividends?
A typical company pays between 2-3% in dividends every year, so if you’re just starting out, don’t expect dividends to help you quit your day job just yet.
In fact, unless you’re investing a significant cash pile, dividends will probably have little effect on your overall finances. Younger investors should consider reinvesting any dividends they receive into more stocks to build up their portfolio. For older investors or retirees, dividends can provide a steady source of income to subsidize their pensions (but they are subject to tax in some jurisdictions).
Sometimes you’ll see companies offer a far higher dividend than the average. These companies should be approached with caution as this is often a signal that they are in trouble and are trying to pump up their stock price.
When shopping for dividend stocks, look for companies that have a long history of paying and even increasing their dividend over many years.
Should I Buy Dividend Stocks?
That’s really a personal choice and will depend on a number of factors, including your risk tolerance and your age.
Older investors tend to lean towards dividend stocks because they are traditionally less risky and provide that extra income for their retirement years. Younger investors have a great advantage in that they can afford to take a little bit more risk and focus on those growth companies that could multiply many times over the years.Like everything in investing though, balance is key. Click To Tweet
Regardless of age, a balanced portfolio should include some large-cap bedrock companies to ensure that an economic downturn doesn’t wipe out your portfolio.
The Downside of Dividends
Dividends aren’t always a good thing, however.
Remember:When a company is paying out dividends to you, that money isn’t being reinvested back into the company. Click To Tweet
This is a company that you part-own, but perhaps giving that cash to you and your fellow shareholders is not the best use of it.
Berkshire Hathaway is what you would imagine as a typical dividend company. It’s been around for decades and has interests in energy, insurance, utilities, railroads—all the old dividend sectors.
But CEO Warren Buffett has never (and will never) pay a dividend to his Berkshire Hathaway shareholders. He reasons that he is one of the best capital allocators of all time and that it would be wasting money to hand it over to people who are less skilled than he is.
And he’s been proven right.
Since the ’80s, Berkshire stock is up over 82,000%, and many people have been made millionaires just by holding onto it.
So while dividends can often be seen as a good way to get a regular return on your investments, they are mostly offered by companies less likely to experience rapid growth.
And if holding off on dividends is good enough for Warren Buffett, it’s good enough for us!
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