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Dividends: Why Are They So Important?

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Many individuals are interested in the stock market and investing. The biggest problem that they usually face deals with the first steps to starting the investment process. Most people believe that they can make money fast by trading stocks. This strategy opens investors up to immense vulnerability because they must begin with large sums of money. On top of that, they have to figure out a strategy that works consistently.

The other option that investors (or potential investors) have is investing in stocks and earning dividends. You are probably asking, what is a dividend? The word dividend comes from the term “profits divided among us all”. A dividend is a cash payment delivered to the shareholders of a company as long as they own at least one share of stock. Additionally, the board of directors of a company have to declare a dividend. Once it is declared the shareholder receives the cash payment in the form of cash into their account or by check (checks were used decades ago and are still used in some cases).

So, how exactly does a dividend work? Once a dividend is declared by the board of directors, the payment could be as little as a penny or as large as the board of directors wish. Usually dividends are derived directly from a company's earnings. In other cases, the dividend may come from a company's operating cash flow. Once the dividend is paid out, the company's share price will fall, reflecting the amount paid out as a dividend. For example, if a company's board of directors declared a 20 cent dividend to shareholder's, then the stock price will fall by 20 cents on that day (which is the ex-dividend date). 

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Now, 20 cents may not sound like a lot of money, and it isn't. The real trick is for an investor to own large amounts of shares of a company. This is when dividends become a big deal. Let's say an investor owns 2,000 shares of the same company that pays out that 20 cent dividend. What is the quarterly payment then? The answer is $400. That isn't too bad, especially for not doing anything. Furthermore, that dividend can increase over time as well as the share price of the stock (although the share price can drop as well).

Historically, many large blue-chip companies have paid out dividends for decades. These same companies tend to also increase these dividends as well. This is the primary reason that many investors like Warren Buffett stick to a “buy and hold strategy”. Yes, even Warren Buffett loves dividends!

Typically smaller companies will not pay dividends for a few reasons. One is to preserve cash to grow in the future. Another reason is that smaller companies tend to keep that extra cash to make debt payments or pay down existing debt. Now don't get me wrong, you can find some small companies that do pay dividends, but they usually pay a very small one, otherwise they may pay it at random.

Usually when companies pay dividends they try and pay them in a uniform manner. In other words, their dividends are very consistent. They typically increase every year or two. Sometimes they can even increase every few months. The board of directors will almost always mention how many payments the company has made in the past in an annual report and which number payment the next one will be. This gives the investor confidence that the board of directors and upper-tier management of the company care about the company’s past performance as well as the future.

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Many investment professionals debate whether dividend payouts are good or bad for a shareholder. Some critics believe that money is better spent re-investing funds back into the company. For example, this means investing in new projects, research and development, hiring more people, or upgrading equipment and/or facilities.

Proponents of dividend payouts suggest that an eagerness to return profits to shareholders may indicate the management may have run out of good ideas for the future of the company. Certain studies, however, have demonstrated that companies that pay dividends have higher earnings growth over time. Moreover, these companies add on the dividend payments to the overall stock performance over an extended period of time. In the end, this increases their Compound Annual Growth Rate (CAGR).

Investors have another option which can give them the upper-hand when investing with a dividend strategy. The concept of a Dividend Reinvestment Plan or DRIP can be initiated. Most brokerage firms give investors the option to use this at no cost. A DRIP allows investors to take their cash payout and reinvest it into the company's stock that they own. This will allow them to acquire more shares (in many cases, fractional shares) if the price falls (or increases). The only down side to a DRIP is that the investor cannot control the price in which the shares are purchased at. These shares will be purchased when the payment is officially delivered to the shareholder and the DRIP will automatically purchase the shares. DRIPs have historically been extremely effective when investing in monthly dividend paying stocks, mainly because the payment comes 12 times a year instead of the typical 4. Investors then have the option to rotate between receiving cash or stock.[1]

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Investors typically look for the highest yielding companies and hope that they could just sit back and receive these payments. In reality, these are typically traps that attempt to lure investors in. A high yield is usually considered to be over 7%. This means that a company is willing to pay you 7% a year, just for owning the stock. Why is this so tempting? Well, have you recently checked what your local bank is paying you if you have a savings account there? How about a Certificate of Deposit (CD) or even a long-term American or Canadian government bond? You probably get the point by now.

These high yields typically never hold up because there is a strong possibility that these companies are actually paying out too much to shareholders. Over time, these high yields are just not sustainable. The average publically traded company has a yield of around 3%.

So, are dividends worth looking into further? You bet they are. Many investors look to them as an option that makes investing a little bit easier. Furthermore, the strategy has been proven to work for decades.

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Comments

Apr 3, 2015 12:49am
Shaddymak
Great Post. I like. Keep writing friend
Apr 4, 2015 3:26pm
Commonwealthnations
Nice one
Apr 4, 2015 3:26pm
Commonwealthnations
Please what are the means of payment on this site?.,,
Apr 4, 2015 3:26pm
Commonwealthnations
This comment has been deleted.
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Bibliography

  1. William O'Neil How to Make Money in Stocks: A Winning System in Good Times and Bad, Fourth Edition. Chicago: McGraw-Hill; 4 Edition, 2009.

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