In fact, dividends play a significant role in my investment policy related to individual stocks. With the exception of Berkshire Hathaway, every business whose shares I own pays a dividend. Given their importance, a series on dividend investing seemed appropriate. This article is the first one in the series.
What is a dividend?
Dividends are a payment by a company to its shareholders of a portion of the company’s profits. Think of a dividend as an investor’s chance to reap the benefits of a company’s profitable performance. While dividends can be paid in stock, that is unusual. Dividends are typically paid in cash.
Typically, and I stress typically, dividend payouts follow the following guidelines:
- Dividends are typically paid to shareholders once each quarter
- The amount of the quarterly dividend payments is typically set by management and the board once a year
- For the largest most solid companies, dividend payments typically (hopefully) rise each year
Many investors not in retirement automatically reinvest their dividends back into the stock, mutual fund or ETF that generated the dividend. In this regard, dividend payments are invisible for many investors.
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Why do Companies Pay Dividends?
And all of this raises an important question. Why do some companies pay a dividend while others do not?
There’s no one answer to this question. For those companies without dividends, the reason is that they need the capital to grow the business. Amazon and Tesla are two examples of well-known companies with no history of payment dividends who are reinvesting their cash flow back into the business.
Other companies, like Berkshire Hathaway, do not pay a dividend for an entirely different reason. As Warren Buffett has explained, Berkshire doesn’t pay a dividend because Buffett and his team can invest the cash an earn a nice return for investors. If shareholders need some income, they can sell some of their shares rather than wait for a dividend payment, which is unlikely under Buffett’s watch.
In the darker corner of the world of public companies, some enterprises do not pay a dividend because of mismanagement. CEOs at some companies have an appetite for big, costly acquisitions and share buybacks that often squander shareholder value.
On the flip side, those companies that do pay a dividend typically do so because the business earns more cash than the company needs to maintain its existing business or reasonably expand into new business lines. Many of the companies are household names like Ford, P&G, Apple, and Microsoft.
How do you determine the amount of a company’s dividend?
Now that we know what dividends are, how do we figure out how much a specific company pays in dividends? The easiest way to do this is to use a finance website such as those offered by Google, Yahoo, or Morningstar. Unfortunately, it’s not quite as easy as that.
If you look at these sites with a focus on a specific company, you are likely to see different amounts for the payout and even different values for the dividend yield (yearly dividend / share price). For that reason, I encourage you to watch the video below where I walk through how to use these sites to get information about dividends and the podcast.
Dividends vs. Interest
At first glance, dividends seem an awful lot like interest payments from bonds. Upon closer scrutiny, however, we quickly realize they are as different as lightening and lightening bugs.
Here are the key differences:
1. Issuers of bonds are contractually required to make the interest payments. Failure to make the required payment timely is a default under the bond agreement. There is no such obligation on the part of companies to pay dividends (at least on the common shares; preferred stock is another matter entirely).
2. Interest payments are typically paid in fixed amounts. Dividends can increase or decrease based on the performance of the company and management’s dividend policy.
3. The par value of bonds does not change. If you buy a $10,000 bond and hold it to maturity, you’ll receive your $10,000 investment back. With stocks, there is no maturity date and the value of shares fluctuate daily. (I should not that the value of bonds fluctuate as well, but not par value or what an investor would receive at maturity.)
The next article in this series will cover key metrics used to evaluate a company’s dividend policy.