Stock dividends can be a fundamental piece of a long-term wealth-building plan. Put simply, dividends are payments made from companies to the shareholders of dividend stocks. This guide explains why and how stock dividends work.
Stock Dividends: The Basics
Suppose you own a small business, like a gym, and the net income is $150,000 per year. If you can do anything with the money, what will you do? Since you need to pay your bills, you’ll probably keep some of that money as personal income. In this scenario, you could perhaps pay yourself $100,000, and use the other $50,000 to grow the business (buy more advertising, get new equipment, open a second gym, etc). In this case, the $100k is like a dividend; you’re extracting money as the owner of the business. In this case, you’re getting about 67% of the money.
Corporate stock dividends are like that, but on a bigger scale. If a company makes $1 billion in net income per year, and consists of 100 million shares, then the earnings per share is $10. If the company pays out $5 per share as a stock dividend, and keeps the other $5 for other purposes, then they have a payout ratio of 50%, and shareholders are enjoying both income and growth. Better yet, they can reinvest dividends in order to grow their wealth more quickly.
Why Stock Dividends Matter
There are only so many things that a company can spend its money on:
When a company is in its early phase, it may make sense to reinvest all earnings into aggressively growing the business. But once they get a certain point, any healthy business should be outputting plenty of free cash. If a business keeps compounding and compounding, the rate of return will diminish.
A company can just let money accumulate on the balance sheet, or use money to reduce levels of debt. This may be a good use of cash if the balance sheet is weak, but if the balance sheet is already strong, then this isn’t a very good use of money. The reason is, cash on the balance sheet earns only a tiny interest rate; a terrible rate of return. The same thing is true for their outstanding debt; a healthy company can issue bonds at very low interest rates, so using cash flow to reduce debt levels when they’re already low wouldn’t provide a very good return.
It’s true that when a dividend is paid, it’s just a transfer of value. The company loses cash, and the shareholder gains cash, which is why a stock price temporarily falls by the value of the dividend when it pays a dividend. But what matters is what happens to that cash over time. If the company keeps it on their balance sheet, it’ll sit there and accumulate tiny returns. If the shareholder gets it, she or he can put it to much better use, like buying more stock.
A company could use cash for an acquisition. Once in a while, this may be valid. But historically, the majority of acquisitions haven’t provided good returns for companies. Companies usually overpay when they make an acquisition, which is good for the shareholders of the acquired company and bad for shareholders of the acquiring company. The occasional strategic acquisition could be smart, and there are a select few companies that have a business model that relies on continually making small acquisitions, but other than that, acquisitions often destroy shareholder value.
The principle goal of a business is to make money for the shareholders. All of the other things that a business does with its cash ultimately lead to the ability to pay money to the owners. Everything else is theoretical; over time, it builds the ability to pay strong dividends. Stock dividends are the final result; payments to the owners of the business.
The only other alternative is for the business to buy back its own stock. Theoretically, when a company buys back its stock, it’s quantitatively identical to a shareholder reinvesting dividends. Either way, the shareholder owns a larger portion of the company.
Companies often time share buybacks poorly, however. They have tons of cash during bull markets and buy back expensive stock, but then when a recession comes and they’re pinching pennies, they’re not buying. So they usually buy more stock when it’s high compared to when it’s low. Plus, you can’t spend share repurchases; you only get that value if you sell shares at market prices, which means there’s an element of market psychology involved when you’re trying to extract your value.
Dividends are the Foundation of a Corporation
From the owner’s perspective, the dividend is the end result. All other value creation in the business, leads directly or indirectly to the company’s ability to pay dividends to its shareholders. Even if a company never pays a dividend, the whole market capitalization of the company is based around the premise that it could, if it wanted to.
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