What Are Dividends?
Dividends are cash payments issued by a company to its investors on a regular basis.
These payments are usually made quarterly but in some cases may be paid on a monthly or semiannual basis.
They represent the investors’ share of the revenue produced by the company. This means that dividend payments are proportionate to the number of shares owned by the investor.
How Do Dividends Work?
Companies offer dividends as a way to entice investors and reward them for providing the capital the company needs to run its business.
Many investors look carefully at these offerings when considering whether to purchase a stock; however, many public corporations do not offer dividends.
Dividends represent a direct cost to companies, and companies with a smaller market share or market capitalization are better served by reinvesting that surplus revenue directly into the business to produce growth in the near term.
Preferred vs. Common Stock
Some investors rely on dividend distributions to support their fixed incomes.
For investors in this financial circumstance, the most stable payments are often found in preferred stock issues. Dividends on preferred stock shares are paid before those paid on common stock shares.
In some cases, investors may also elect to have their distributions automatically reinvested in the stock, raising their share count over time. This is known as a dividend reinvestment plan (DRIP).
Even though many companies place high priority on keeping their distributions competitive, the issuance of dividends is solely at the discretion of the company.
Companies may choose not to issue dividends or to lessen their payments when cash gets too tight.
What Is Dividend Yield?
Dividend yield is the percentage of a stock’s dividend relative to its share price.
A stock that trades for $50 per share and pays a dividend of $1 has a yield of 2 percent—1 divided by 50 is .02, or 2 percent.
When shopping for stocks, one can use dividend yields to compare the distribution offerings of various stocks irrespective of their share price.
This apples-to-apples comparison helps prospective investors understand which company is a “better buy” if they are focused on the dividend payment stream.
For example, Stock A has a share price of $100 and offers a dividend of $2, whereas Stock B has a share price of $20 and offers a dividend of 50 cents.
Based solely yield, Stock B actually pays more of per dollar invested than Stock A.
The yield percentage for Stock B is 2.5 percent (.50/20).
The yield percentage for Stock A is 2 percent (2/100).
If an investor were to purchase five shares of Stock B totaling $100, that investment would, all other things being equal, produce more in dividend income than a single share of Stock A for the same price.
The Dangers of Focusing on Dividends
The offering of dividends is done by companies to attract investors, and it works.
If a company offers dividends, they are automatically deposited directly into the investor’s bank account or brokerage account. On the surface, this appear to be easy money.
This kind of thinking can be dangerous and can lead investors to focus on the wrong fundamentals and make risky investment decisions as a result.
Abnormally high yields can be used to disguise weakness in the balance sheet of distressed companies.
In general, chasing yield can lead investors to skip important due diligence steps and ignore red flags or other warning signs.
As investing legend Benjamin Graham put it:
No intelligent investor, no matter how starved for yield, would ever buy a stock for its dividend income alone; the company and its businesses must be solid, and its stock price must be reasonable.