There are two primary ways to make money off of an equity position: capital appreciation and dividend income. Dividend yield is an oft-quoted, but often misunderstood aspect of a stock’s virtue. Before accounting for stock dividends in your investment strategy, take the time to educate yourself on their merits.
Why do Companies Issue Dividends?
Companies generate dividends from excess cash flow, which remains after fulfilling all obligations, including expenses and debt payments. After meeting obligations, a company can decide to retain excess cash for future investment or distribute it to shareholders.
Traditionally, these payouts would come in the form of dividends. In more recent times, companies have increased the frequency of stock buybacks (much to the chagrin of Bernie Sanders). While they have received a lot of bad publicity in recent times, stock buybacks largely serve the same function as dividends due to the fact that, as companies buy their own shares, the number of shares outstanding declines. In turn, the earnings per share (the dollars of earnings per share outstanding) rises because there are fewer shares outstanding, which theoretically means that the stock price then increases. One of the reasons companies do this is to offset the dilutive effect of stock issuances. Many employees of large companies (i.e. Facebook, Tesla) will be partially compensated in shares of their company’s stock, and in order to counteract these shares being issued, companies will buyback their own shares on the open market.
Regardless of the chosen option, both dividends and stock buybacks aim to distribute earnings to shareholders.
What Makes Stock Dividends Attractive?
Many investors are attracted to the perceived “stickiness” of dividends. To indicate the strength of their operations, companies will often reference their track record of issuing dividends without forgoing a payment. Companies see stock buybacks as occasional events with excess cash, whereas dividends offer consistency and reliability. For investors relying on the income generated from their portfolio, consistent divided payments can help in budgeting to determine expected cash inflows.
How Much Should Dividend Yield Weigh Into Your Investment Strategy?
Much attention focuses on the appeal of a high dividend yield. As I mentioned in a previous piece, emphasizing dividend yield at the expense of other financial fundamentals is excessive. Common shareholders receive dividend payments after fulfilling debt servicing and preferred dividends obligations since these payments are optional. Income from dividend payments in a taxable account is subject to ordinary income tax, without a capital gains deduction.
As an investor, your concern should be on the total return of an investment, rather than just dividend payments. Earning income off of a position is great, but your overall return can still be negative if you experience sufficient capital depreciation to offset dividend payments. And remember, a stock’s dividend yields express as a percentage of its price. Beware of an “attractive” yield; it could be due to a sharp stock price drop, risking dividend reductions.
There are no guarantees in investing. At first blush, a high dividend yield is always appealing. Just remember to always do your due diligence. After all, it’s your hard earned money that’s at stake.
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