if not all of them, into growing the business.
✓ Pay down debt: If, in addition to selling shares, companies borrowed money to raise capital, they may use profits to pay down the debt, thereby reducing the expense of their interest payments.
✓ Buy back shares: Companies may use profits to buy back shares that they feel are undervalued, or for other reasons. In some cases, they initiate buybacks to artificially inflate the share price and improve investor confidence in the company.
✓ Pay dividends: Paying dividends is a form of profit sharing – spreading the wealth among the company’s owners, the shareholders.
A company’s dividend policy generally reflects the board of directors’ and shareholders’ preferences in how to use profits. Two schools of thought govern their decision:
✓ Pro growth: This school believes a company is better off reinvesting its profits or using profits to pay down debt or buy back shares. This strategy makes the company more valuable, and the share price rises accordingly. Shareholders benefit when they sell their shares for more than they paid for them.
✓ Pro profit-sharing: This philosophy stems from the belief that shareholders own the company and should share in its profits.
Other factors can also influence dividend policies. For example, the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA), which lowered the maximum tax rate on dividends from 39.6 percent to 15 percent, led companies making up the S&P 500 Index to boost their dividend payments. For more about how tax legislation can affect dividends, check out Chapters 3 and 11.
The advantages of dividend investing
Receiving dividends is like collecting interest on money in a bank account. It’s very nice but not exciting. Betting on the rise and fall of share prices is much more exhilarating, especially when your share prices soar. Placing excitement to the side, however, dividend stocks offer several advantages over non-dividend stocks:
✓ Passive income: Dividends provide a steady flow of passive income, which you can choose to spend or reinvest. This attribute makes dividend stocks particularly attractive to retirees looking for supplemental income.
✓ More stable companies: Companies that pay dividends tend to be more mature and stable than companies that don’t. Startups rarely pay dividends because they plow back all the profits to fuel their growth. Only when the company has attained a sustainable level of success does its board of directors vote to pay dividends. In addition, the need to pay dividends tends to make the management more accountable to shareholders and less prone to taking foolish risks.
✓ Reduced risk: Because dividends give investors two ways to realize a return on their investment, they tend to have a lower risk-to-reward ratio, which you can see in less volatility in the share price. A stock with lower volatility sees smaller share price declines when the market falls. Low volatility may also temper share price appreciation on the way up.
✓ Two ways to profit: With dividend stocks, your return on investment (ROI) increases when share prices rise and when the company pays dividends. With non-dividend stocks, the only way you can earn a positive return is through share price appreciation – buying low and selling high.
✓ Continued ownership while collecting profits: One of the most frustrating aspects of owning shares in a company that doesn’t pay dividends is that all profits are locked in your stock. The only way to access those profits is to sell shares. With dividend stocks, you retain ownership of the company while collecting a share of its profits.
✓ Cash to buy more shares: When you buy X number of shares of a company that doesn’t pay dividends, you get X number of shares. If you want more shares, you have to reach into your purse or pocket to pay for them. With dividend stocks, you can purchase additional shares by reinvesting all or some of your dividends. You don’t have to reach into your pocket a second or third time. In most cases, you can even enroll in special programs that automatically reinvest your dividends.
✓ Hedge against inflation: Even a modest inflation rate can take a chunk out of earnings. Earn a 10-percent return, subtract 3 percent for inflation, and you’re down to 7 percent. Dividends may offset that loss. As companies charge more for their products (contributing to inflation), they also tend to earn more and pay higher dividends as a result.
✓ Positive returns in bear markets: In a bear market, when share prices are flat or dropping, companies that pay dividends typically continue paying dividends. These dividend payments can help offset any loss from a drop in share price and may even result in a positive return.
✓ Potential boost from the baby boomers: As more baby boomers reach retirement age and seek sources of supplemental income, they’re likely to increase demand for dividend stocks, driving up the price. Nobody can predict with any certainty that this will happen, but it’s something to remain aware of in the coming decades.
The risks
There’s no such thing as safe investing, only safer investing. You can lose money in any of the following ways:
✓ Share prices can drop. This situation is possible regardless of whether the company pays dividends. Worst-case scenario is that the company goes belly up before you have the chance to sell your shares.
✓
Companies can trim or slash dividend payments at any time. Companies aren’t legally required to pay dividends or increase payments. Unlike bonds, where failure to pay interest can put a company into default, a company can cut or eliminate a dividend any time. If you’re counting on a stock to pay dividends, you may view a dividend cut or elimination as losing money.
✓ Inflation can nibble away at your savings. Not investing your money or investing in something that doesn’t keep pace with inflation causes your investment capital to lose purchase power. With inflation at work, every dollar you scrimped and saved is worth less (but not worthless).
People often invest more time and effort planning for a weekend vacation than they do preparing to become an investor. They catch a commercial for one of those online brokerages that makes investing look so easy, transfer some of their savings to the brokerage or roll over their IRA (individual retirement account), and try to ride the waves of rising investment sentiment to the land of riches.
A more effective approach is to carefully prepare for the journey before taking the first step. The following sections serve as a checklist to make sure you have everything in place before you purchase
