When a company makes profit, it is inclined to do something with it that has to benefit both the company and the investors. Some companies use this to pay off their debt, reinvest in themselves in a form of retained earnings or buy back its stocks to raise the value of their shares. And some companies choose to distribute their earnings to their investors which is known as dividend.
Dividends may be quoted in terms of the amount each share receives, known as (Dividend Per Share or DPS), or it can also be quoted in terms of a percentage of the current market price known as (dividend yield). Dividend paying must be approved by the shareholders and may be structured as a one time-special dividend, or as an ongoing cash flow to owners and investors.
Mutual fund and ETF’s shareholders are often entitled to receive accrued dividends as well. Mutual funds pay out interest and dividend income received from their portfolio holdings as dividend to the fund’s shareholders. Also, realized capital gains from the portfolio’s trading activities are generally paid out as a year-end dividend.
Dividends are often not common among start-ups, high growth companies, or companies in sectors that have very high growth and expansion costs such as Biotech and Technology. This is because all their earnings are reinvested to help sustain higher-than-average growth and expansion. Larger, well established companies tend to pay regular dividends to its shareholders to help maximize shareholders wealth creation. If a company regularly pays dividend to its shareholders, it’s a positive sign for the health of the company. And if a company suddenly stops paying dividend, it’s usually a sign of trouble either in the company or the market as a whole.
WHY MANY INVESTORS PREFER DIVIDENDS.
Investors in many circumstances prefer to receive their share of the company’s profit as dividend instead of having that money reinvested in the company. Don’t get it wrong, usually investors would like the profit of the company reinvested when the company is young and in a fast growing sector as we see in many tech companies. But as soon as the company is well established and having a normal growth, investors want their part of the earning paid to them. This usually has something to do with the saying “A bird in hand is worth two in the bush”. Investors turn to prefer receiving dividend now to a potential capital gain because of the uncertainty of the latter.
Another reason why many investors like to receive dividend is the tax advantages they might have. In some countries income from dividend is treated at a more favorable tax rate than the ordinary income. Investors seeking for a tax-advantaged cash flow may look for dividend stocks in order to take advantage of the potentially favorable taxation.
Owning dividend paying stocks is a good way of building your finances.