What are Dividends?

by | Mar 29, 2023 | Research

When determining if a stock is a worthwhile investment, investors often consider the amount of income a company makes relative to its debt, outstanding shares, and price. But another important consideration is what the company does with those earnings.

Companies typically have two options when it comes to profits – reinvest the funds to grow the business or pay earnings to investors in the form of dividends. This begs the question – what are dividends and how could they benefit investors?

What are dividends?

Dividends are payments that companies make to shareholders to distribute earnings. The company’s board of directors determines whether the company will pay a dividend and how much that dividend will be.

Dividends definition: Payments that companies make shareholders to distribute earnings.

Companies can pay dividends at any time. However, most firms that issue dividends do so at the end of each quarter. Once quarterly financial data is calculated, the company’s board of directors meets and determines the timing and amount of any dividend they plan to offer.

Why do companies pay dividends?

Companies often pay dividends when they believe the dividend will provide more benefit to shareholders than reinvesting in the business. For example, if a company believes that expanding into a new market would benefit shareholders in the long run, they may choose to reinvest profits rather than paying them as dividends. On the other hand, if the company does not have any strategic investment opportunities available, they may choose to pay profits to shareholders as dividends.

Which stocks pay high dividends?

Any company can pay a dividend, but some firms and sectors of the market have a stronger track record of paying dividends than others. In general, established companies with relatively predictable income – like utilities – are more likely to pay reliable dividends.

Younger companies and firms that are rapidly expanding tend to reinvest profits in the business rather than paying dividends to shareholders. For example, tech startups rarely pay dividends. However, these trends do not apply in every scenario or to every company. So, it is important to thoroughly research each stock you plan to buy or partner with a financial advisor who has experience trading individual stocks.

The Pros and Cons of Dividend Stocks

While it may seem like companies that pay dividends are better investments than those that do not, the reality is often more complicated. That’s why you should consider these pros and cons before adding a high dividend stock to your portfolio.

Pro: Dividends Provide Reliable Income

If your main investing objective is generating income, you may find that high dividend stocks match your goal. Companies with a strong track record of paying dividends could provide predictable income on a quarterly basis.

Con: Dividends Are Taxed as Income

If you’re investing in a non-retirement account, the tax consequences of dividends could be a downside. There are two ways to profit from stocks – (1) dividends and (2) capital appreciation. Capital appreciation refers to an increase in the value of your shares. Dividends are taxed as ordinary income while capital appreciation is taxed at capital gains rates – which are typically lower. Additionally, dividends are taxable in the year they are received while capital appreciation is only taxable when you sell your investments.

Pro: Dividend Stocks Can Be Less Volatile During Recessions

Dividend stocks tend to outperform growth-oriented companies during recessions for a few key reasons. First, companies with a solid history of paying dividends tend to have stable cash flows. In addition, a predictable dividend stock in a steady market sector can be seen as a safe haven – and an alternative to bonds – when there is turmoil in the overall markets.

Con: Companies That Pay High Dividends May Have Less Room to Grow

Companies that pay higher dividends have often reached the peak of their business or plateaued for the long-term. For example, an electric company that pays regular dividends may have reached all potential customers in their area and therefore have little room left to expand – resulting in a stock price with little room to grow. For this reason, you may sacrifice capital appreciation to achieve steady income with some dividend stocks.

These are just a few of the factors you must consider before investing in a high dividend stock. Each company is unique and must be considered individually when determining whether a stock is right for your situation. An experienced wealth manager can help you quantify your goals and choose investments to help you reach them.

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Article Topics: Stocks