As the markets turn and churn, the stock-picking advice that has resonated across the board from advisors and analysts alike has been: If you’re going to invest in equities, look for dividend payers. Choose companies with strong balance sheets that are also paying a dividend. You’ll also hear that a large percentage of the increase in the value of the stock comes from re-investing those dividends. But what does that mean? What is this dividend, where does it come from? Is there anything to guarantee that they will keep getting paid? What are you doing when you re-invest your dividends?
What is a dividend?
To put is simply, as an investor, a dividend is your share of the company profits. Corporations exist for one reason alone – to make money for their shareholders. It can be debated that corporations exist to provide a good or service, but the management of every successful company knows that once the daily business is done, their job is on the line if they haven’t turned a profit. Who are these shareholders to whom they are accountable? If you own stock in a publicly traded company, it’s you.
Where does a dividend come from?
Once the company has become profitable, the management has to make one of two choices. The first is that they can keep the money that they’ve made and say that at some point in time they will reinvest it into the company to make more money. When they do this, the funds on the balance sheet are called ‘retained earnings’. The second option is to pay it out to the shareholders. If you own stock, each share that you own will have an amount of dividend attributable to it. This makes sure that all shareholders of publicly traded companies receive the same percentage of compensation for their ownership.
Is there anything to guarantee that dividends will keep getting paid?
Unfortunately, no. Dividend payments are made when there is sufficient cashflow to pay them out. However, management knows that missing or reducing a dividend payment is looked on unfavorably by analysts and the investment community, and can be a sign that the company is in trouble. They will do everything in their power to make sure that the company is able to meet what they view as an obligation to their owners, the shareholders.
What are you doing when you re-invest your dividends?
Re-investing your dividend means you’ve indicated that, you would like to use the money to increase your ownership in the company, instead of taking a cash payment. The dividend payment is used to purchase more shares which does two things:
1) Increase the amount of dividends that you will receive in the future, as the dividend is paid out on a per-share basis.
2) Give you the opportunity to have a greater participation in the company growth, as your ownership has increased.
The decision is yours. Whether you take them in cash, or reinvest them, a dividend is a good way of receiving value in return for your investment in a publicly traded company.