Dividends explained- risk/reward, positives and negatives

Entry about the relevance of dividends for investors...

What is a dividend?

Well, its money divided. If a publicly listed company makes money it can either choose to reinvest the money in the company, or it can pay something back to investors.

Positives and Negatives

Many investors believe that paying investors dividends has to be a good thing, as you are getting money back. I don't think that dividends are necessarily good or bad- they are part in parcel of analyzing a stock. A bad company with a good, high dividend does not change a thing, its still a bad company. An OK company that pays a dividend, and is likely to always pay a dividend, is a safe bet, this doesn't mean its a good bet though.

Further into the discussion on dividends..

If a business is growing it normally requires money to grow, ordinarily. So, by paying a dividend, it can, but not always, be limiting the growth of the company. This is especially true of smaller companies that require the profits they are making to be reinvested in the company. So, metaphorically speaking, a growth company reliant on the reinvestment of profits is shooting itself in the foot by paying out a dividend. The first time I heard this argument was by Philip A Fisher in his book 'Common Stocks and Uncommon Profits'. I'm sure many of my dear readers have heard of Warren Buffett(if not read into him!). His company, Berkshire Hathaway is huge. But, and very importantly, it's still growing. Does he pay a dividend? No. His company uses their dollars better than by redistributing them as dividends. So this leads me onto- when is purchasing a company for its dividend a good idea?

Potential risks and rewards for dividend plays

This, and everything on this blog, is my own humble opinion. Now that's out of the way, I can tell you when I buy a stock for its dividend. Never. I have to like the stock first then I look at the dividend. In a previous entry, for those that have read it, I do mention a stock with a good dividend. I didn't buy it for the dividend. I have been monitoring it since 2005. Since then its dividend (actually in the past year), because the stock price has halved;dividends are intrinsically tied to the price. The dividend is a profit percentage of every share, as already mentioned so- if the price goes down the dividend yield/percentage, goes up. So your immediate return as an investor, goes up. So when do I buy a dividend play- when, and only when, a good company is undervalued, thus its dividend goes up, I get the company on the cheap, with a huge dividend thrown in as a bonus. Sweetens everything.


Generally, dividends get paid out when the company has excess cash. As investors we need to know why and why isnt the company using the cash to grow the business? This really depends on the market, the opportunity to grow/expand and the cash available. My recent dividend play makes 10b a year, therefore they've got excess cash.

Who does the dividend benefit? Investors, right. Who else? There are sometimes companies that are majority owned by the management, or institutional investors. They sometimes have shorter term horizens, thus require a dividend to satisfy those horizens. That can mean a stunting of growth for enterprising investors (me and you).

What if you want income without selling your shares?

If you are in a different position to myself, at 23, and are looking for conservative investments that provide an income, dividend plays are good in that they fulfil that brief. Choose well established companies, those that always pay their dividends, and with earnings growth that justify dividend growth. I would also argue that everyone needs to adjust their own portfolios to their own needs and long term goals.

An example.

Lets look at two hypothetical companies. ABC and XYZ. ABC is a growth company, reletatively new, with good potential and a decent 10 year record. It pays no dividend. XYZ has been around for 60 years, has modest growth in both earnings and dividends.

Let's now look at examples of what happens long term to your money.

Company

ABC XYZ

EPS(Earnings per share)

Year 1 10 10
Year 2 15 11
Year 3 22 12
Year 4 26 13
Year 5 32 14.5

Dividend per share

Year1 0 1
Year2 0 1.1
Year3 0 1.2
Year4 0 1.3
Year5 0 1.4



Peter Lynch, Warren Buffett and Phillip Fisher all state that share price appreciation happens when good companies grow their earnings over the years. Long term, earnings are the main determinant of where a stock goes. Based on that, and through examples I will scan at a later date to illustrate, the outcome of the two companies is interesting. Earnings appreciation has more than tripled for ABC(300%), as opposed to 40% increase from XYZ. What happens then?
ABC's stock quadruples, where as XYZ's stock goes up by 50-60%.

10k in ABC would produce 40K in 5 years whereas the same investment would provide roughly 21K (16K stock price appreciation, plus the dividends). Big difference. Risk has its' rewards. (in further blog entries I'll show you that its not that hard to find these growth stocks)
These are fictitious examples, but roughly guide the reader to what happens in reality.

For the disgruntled reader there will be real examples posted in further days, so keep checking back if you don't believe me! For the impatient reader you can buy Peter Lynch's book 'One up on Wall street' with plenty of examples, from the my favourites section on the left hand side of my blog, it is very good read...

Hope that helps...