How Do Dividends Work?

Sometimes companies give some of their profits directly to their investors in the form of dividends.

Dividends are the cash payments stockholders receive based on a company’s earnings. Not every company pays dividends, but you’ll find that a large portion of established stable companies do. Dividends are the only way, apart from using strategies around options, that an investor can profit from his stock without selling off his shares.

Profits made by a company are spent in one of two ways. They are reinvested into the company to promote growth, with the idea of creating more profit and more robust stocks in the future. And they are distributed to shareholders as dividends. Reinvesting for growth is only viable as long as the company is growing at an above average pace.

Every company, however, will at some point reach a plateau, where they are not significantly increasing profits or customer base. Now they are no longer justified in reinvesting money; it’s not working to grow the company, and reinvesting it may just be throwing it away. At this point, most companies start paying dividends to their stockholders.

An example is Microsoft, everyone’s favorite investment. It was inevitable that at some point they’d reach market saturation; there are a limited number of computers to put Windows on, and a limited number of people to buy them. What happened at Microsoft was a limitation of projects. They had dozens of projects, but they didn’t need any more money to fund them. Instead of putting money into worthless projects or padding the budgets of existing ones, in 2003 Microsoft opted to start paying a dividend to shareholders.

Once a company starts paying dividends, you can expect its growth to decrease. That doesn’t mean it is suddenly a worthless company. It means, rather, that it will no longer grow in leaps and bounds. Sometimes it can be a good idea to invest in a dividend-paying company because dividends can be a reflection of the general health of the company, their stability, and their profitability. Dividends can also be viewed as a guaranteed bit of return on investment that’s not dependent on market swings.

But dividends do not always signal a good investment, so you should be careful. In particular, dividends are susceptible to immediate rather than deferred tax. When an investment distributes a dividend, you must pay tax on that dividend in the same year. However, if your investment is earning by shear capital appreciation, your tax is deferred until you sell the stock. Non-dividends, therefore, give you more control over when you pay the taxes.

You should watch dividends compared to the company’s income. A dividend payout of over 50% of the company’s net profit may be a signal of danger; even large stable companies have research and development to invest in, and when they choose to pay stockholders rather than try to grow their profits, it may mean they are worried about the health of the company and anticipating a stock selloff.

Remember, though, that earnings are not as secure and solid a number as dividends. Even with Sarbannes-Oxley, aggressive accounting practices warp and twist numbers, and you must be vigilant for this problem.

And if a company has paid dividends for a long time, then suddenly stops, you can expect a panicked selloff of stock by some shareholders. This is seen, fair or not, as an announcement that a company is in trouble. Even though a company doesn’t have to pay dividends every quarter, most companies that start paying them do everything possible to remain able to pay them. Keep this in mind, because once a company starts paying dividends, it is much harder to reverse course and instead put the money towards company growth.