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 (see my piece on Common Investing Mistakes). Before accounting for stock dividends in your investment strategy, take the time to educate yourself on their merits.
Why do Companies Issue Dividends?
Dividends are derived from a company’s excess cash flow (i.e. the money left over after a company has met all of its obligations, including administrative expenses and debt payments). After obligations are met, a company is left with the option to either retain that excess cash for future investment or pay it out 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 which option is selected, the goal of both dividends and stock buybacks is distributing 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. Whereas stock buybacks are viewed as more of a one-off event when companies have excess cash, dividends are viewed as being more consistent and reliable. 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 is made of the appeal of a high dividend yield. As I mentioned in a previous piece, too much emphasis is placed on dividend yield at the expense of other financial fundamentals. Dividend payments are optional and subordinated to other commitments, as they can only be issued to common shareholders after debt servicing obligations have been met and preferred dividends have been paid. Further, the income earned on dividend payments is taxed as ordinary income without the benefit of a capital gains deduction (if you are holding your positions in a taxable account).
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, dividend yields are expressed as a percentage of a stock’s price. Don’t be blinded by an “attractive” yield – the stock price may have simply experienced a precipitous fall and the dividend payment could easily be slashed.
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.
Opinions are those of the author and may not reflect those of BMO Private Investment Counsel Inc., and are not intended to provide investment, tax, accounting or legal advice. The information and opinions contained herein have been compiled from sources believed reliable but no representation or warranty, express or implied, is made as to their accuracy or completeness and neither the author nor BMO Private Investment Counsel Inc. shall be liable for any errors, omissions or delays in content, or for any actions taken in reliance. BMO Private Investment Counsel Inc. is a wholly-owned subsidiary of Bank of Montreal.
