I was asked recently by a co-worker, "what is a dividend?" after having a brief discussion on investing and the like. I had never really thought that this was unknown knowledge to certain people. I take for granted, in my studios nature of observing investments, that the term "dividend" is well known and generally fairly obvious. I was proven today that my thinking was incorrect and naive. I would like to try to explain today what exactly a dividend is.
Per Investopedia, a dividend is:
A distribution of a portion of a company's earnings, decided by the board of directors, to a class of its shareholders. The dividend is most often quoted in terms of the dollar amount each share receives (dividends per share). It can also be quoted in terms of a percent of the current market price, referred to as dividend yield.
This is a fair summation of what exactly a dividend is. The distribution of earnings, which can be in the form of money, shares or even property, is a method in which the company tries to reward the shareholder for investing in the company. It is primarily because of this distribution that I invest in dividend growth stocks. I want to know that the company is healthy and producing profits. I can look at balance sheets all day long, but the best way to know a company is healthy and actually has cash is when they return some of that money directly to me. It's the "proof in the pudding" as one would say.
Not all companies return a portion of earnings back to shareholders. Most growth companies, which are defined as any company that is growing faster than the relative market, do not pay a dividend. That is because the growth company usually would rather reinvest the earnings back into the business (retained earnings) to keep the growth rate high. This could be perceived as a positive or a negative, depending on your point of view. For some, they like that the company has better ideas and perhaps the company can grow that money at a better rate than the investor. Also, this saves on taxes, so as to avoid double taxation (at the corporate level on earnings, and again on the dividend paid to the investor).
For me, I prefer not to invest in growth companies. First, there is no guarantee that the company can actually get a better rate of return on the money than I can. Second, I like to reinvest the dividends and therefore compound my investment. I can't reinvest capital when I'm not receiving any from the company I'm investing in. There are cons to receiving dividends in lieu of the company retaining the earnings. I get taxed on the dividend, which is currently at a 15% federal tax rate. That means only 85% of those earnings are hitting my wallet. Some view this double taxation as unfair and a natural disadvantage to dividend investing. Also, there is perhaps the chance that I won't grow that money as fast as the company can.
I view receiving dividends as a positive, however, because it gives me freedom of choice in how to reinvest that returned capital. Perhaps reinvesting the dividend back into the company that paid it is the prudent choice, because that company is undervalued. Perhaps, sitting on cash due to an inflated market is the best move. Or, I could be at the age where I'm living off my dividend income and I'm trying to pay bills and meet expenses. No matter the situation, with the distribution of a portion of earnings in my hand, I can choose how to use it. I think that's just fantastic.
Thanks for reading.
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