The pull of dividend income has become a very powerful one and there is no sign of any decline in its popularity. In this short article, we explore why companies that pay dividends are in such demand, why investment trusts are such a great way to make cash, and what to look for when you are investing for income.
Some of the primary reasons why dividends matter for investors include the fact they substantially increase stock investing profits, they provide an extra metric for fundamental analysis, they reduce overall portfolio risk, they offer tax advantages, and they help to preserve purchasing power of capital.
Also the way dividends are treated in regard to taxes makes dividends a very tax-efficient means of obtaining income. Qualified dividends are taxed at substantially lower rates than ordinary income.
Well-established companies that pay dividends typically increase their dividend payouts from year to year. There are a number of “dividend aristocrats,” or companies that have continuously increased their dividend payouts for more than 25 years consecutively.
Unique basics of stock market investing is market risk, or the inherent risk associated with any equity investment. Stocks may go up or down, and there is no guarantee they increase in value, but while investing in dividend-paying companies is not guaranteed to be profitable, dividend stocks offer at least a partial return on investment that is virtually guaranteed. It is very rare for dividend-paying companies to ever stop paying dividends, and in fact, most of these companies increase the amount of their dividends over time.
Additionally, in this low-interest-rate environment, the dividend yield offered by dividend-paying companies is substantially higher than rates available to investors in most fixed-income investments such as government bonds.
One of the simplest ways for companies to communicate financial well-being and shareholder value is to say “the dividend check is in the bank.” Bonuses, those cash distributions that many companies pay out regularly to shareholders from earnings, send a clear, powerful message about future prospects and performance. A company’s willingness and ability to pay steady dividends over time and its power to increase them; provide good clues about its fundamentals.
Before corporations were required by law to disclose financial information in the early decades, a company’s ability to pay dividends was one of the few signs of its financial health. Despite the Securities and Exchange Act depending with the county’s regulations and the increased transparency it brought to the industry, dividends still remain a worthwhile yardstick of a company’s prospects.
Typically, mature, profitable companies pay dividends. However, companies that do not pay dividends are not necessarily without profits. If a company thinks that its own growth opportunities are better than investment opportunities available to shareholders elsewhere, the company should keep the profits and reinvest them into the business. For these reasons, few “growth” companies pay dividends. But even mature companies, while much of their profits may be distributed as dividends, still need to retain enough cash to fund business activity and handle contingencies.
Dividend-paying businesses have therefore been highly sought-after over recent years and all the more so in the prevailing environment of sluggish, uncertain growth in most developed economies. After all, once you have been paid a dividend, it is yours to keep, a real return, unlike a rising share price which could slip back again.
But equity income has other, inherent, attractions. Not only do these businesses provide a regular income stream, but they have historically been the better-established, well-run, profitable companies with cash to spare for shareholders.
Moreover, with inflation now on the rise (CPI inflation hit 1.2%, a 25-month high, in November last year) people are once again thinking about how to ensure their money will hold its real value over the years. Stock market investments are very attractive in that respect, as companies tend to raise their own prices to maintain their profits when costs are rising.
Even for investors who do not currently need an income from their investments, dividend-paying companies can work brilliantly, as reinvested dividends boost total returns enormously over the long term. That is because those dividends are used to buy more shares, which themselves pay dividends.
To put that into perspective, according to an investment report, since 2002, Kenya equities with dividends reinvested have returned 5.4 per cent a year on average. When dividends are stripped out, the average annual total return falls to just 0.8 per cent a year.
And with companies that focus on growing their dividend payouts each year, the power of compounding is even more impressive. A company that raises its dividend by just 3% a year can double its payout in less than 25 years.