Most investors buy stocks hoping for price gains. Dividends, on first glance, look so insignificant that most investors end up either ignoring them or considering them a minor feature of their stocks.
Yet, a closer look could help you understand how endlessly fascinating these regular cash flows can be. After all, dividends are cash payments you’ve earned without lifting a finger. They’re easy to predict, because the companies that pay them actually announce the dividends for the year ahead. They are also highly reliable, because managers hate cutting the dividend rate and disappointing income-seeking investors.
Best of all, if you manage to create a sizable, rock-solid dividend portfolio, you can live off the income from your investments for the rest of your life.
If you’re still unconvinced of the merits of dividend investing, here are the five most interesting facts about them that might change your mind:
Dividends are the same as buybacks
Well, nearly the same. Dividends and buybacks are ways to reward shareholders of a company with the cash the company has made. The cash can either be paid out to shareholders (in the form of dividends) or used to buy the company’s shares and increase the proportion of the company each shareholder owns.
In theory, the effect on shareholder wealth should be nearly the same regardless of the strategy. However, in practice companies can sometimes overpay for a their stocks or dividend tax rates can chew into the overall return. We’ve tackled this subject in an article done last year. You can find it here.
Dividends have an impact on price
Here’s another interesting fact – dividends have a direct impact on the share price. On the ex dividend date the stock price is adjusted downward by the amount of dividend being paid. In most cases this downward adjustment is proportionate to the dividend, but in some cases the adjustment isn’t complete. This leaves an opportunity for traders who want to deploy a ‘Dividend Capture’ trading strategy.
Taxes have an impact on price change
Since 2003, the tax on dividends has been roughly the same as the tax on capital gains. This means the stock price should adjust fully downward by the dividend amount on the ex dividend date. However, if these two rates are different you can still estimate the change in stock price on ex dividend date using the following formula:
Dividend x (1- Dividend Tax Rate) / (1 – Capital Gains Tax)
Borrowing to pay a dividend is common
Traditionally, companies paid a dividend from the corporate cash pile or a fixed ratio of earnings. This meant there was actual free cash flow supporting the dividend paid out to investors. However, companies have been getting more creative with their cash flows in recent years. Some borrow money to pay a bigger dividend than they can afford. Others, such as Apple, borrow to pay a dividend they can easily afford to avoid repatriation taxes. The way the dividends are funded is nearly as important as the yield itself. Income seeking investors need to look under the hood of their dividend paying companies to find out what do dividend stocks pay.
Dividends make up a significant portion of total return
Investors often ask what do dividend stocks pay and whether it is enough. A quick look back at total returns on the S&P 500 shows exactly why dividends matter. Estimates suggest that reinvested dividends have contributed nearly 60% to the total return over a 20-year period. Since January 1988, reinvesting the dividends on the S&P 500 would have added an extra 2.75% to the average annual return. These dividend cash flows may seem like a small drop in the bucket today, but with the power of compounding they tend to add a substantial amount of wealth for shareholders.
There’s a lot more to dividends than what’s apparent at first glance. Dividends have a close link to profits, future prospects, management estimates, and effective tax rates. Perhaps most investors significantly underestimate the contribution of dividends to overall performance.
Picking out great dividend stocks is the key to a rock solid income portfolio for the long term.