Whether your aim is to maximise current income [1] or grow your capital, buying shares that pay dividends can be a good match for individual investors who want to directly hold a portfolio of shares, but who don’t want to succumb to excessive trading and speculative activity.
Though it’s been nice to see the increased interest [2] in dividend shares over the past few years [3], there remains a lot of misunderstanding about dividends, the proper way to manage a dividend portfolio, and how to separate good dividend shares from bad ones.
In the next few months, my aim is to start from the ground up, to help create a lasting source of dividend education for and with the Monevator community.
What are dividends?
To understand what dividends are, first we must review what a share represents to an investor.
When you buy a share of a company, you’re literally doing just that – buying a share of the company itself – and by doing so you become part-owner of that business. You may not have much say in the company’s day-to-day operations, but you nevertheless get to share in the company’s profits and normally receive the right to vote on corporate policy.
As a company grows and matures, it typically becomes more profitable (otherwise it probably wouldn’t have lasted that long) and produces more cash flow. Concurrently, however, the maturing company frequently finds that it has fewer suitable investments in which to reinvest all the extra cash it’s generating.
When this happens, companies often decide to return some of the extra cash to shareholders in the form of dividends rather than hoard it or reinvest it in value-destroying projects. And because you own a fractional share of the company, you are entitled to receive your proportional amount of the dividend paid to shareholders.
We’ll discuss dividend policy in more detail in a future part of this series, but for now the important thing to remember is that dividends are cash paid by companies to shareholders.
This may seem elementary, but it is an absolutely critical concept to remember when evaluating dividend-paying shares: unless the company generates more than enough cash to sustainably fund the dividend, the dividend is more likely to be cut or suspended.
From time to time we hear about companies cutting their dividends, and there’s always a group of investors that didn’t see it coming. In future articles, I will introduce ways to notice a risky dividend by paying attention to cash flows and a company’s financial health.
What dividends are not
One common misconception about dividends is that they’re paid out of a company’s profits.
It’s easy to see why some investors may think that’s the case as the ‘dividend cover’ ratio – earnings/dividends – is the primary dividend health metric found in financial data sites and analyst reports.
The problem is that earnings are an accountant’s opinion and do not 100% translate into tangible cash. A company with aggressive accounting policies, for example, can artificially boost reported earnings for a time whilst generating less actual cash flow. This can make the company’s dividend look healthier than it really is.
As investor curiosity about dividends has increased, so has the misconception that income generated from dividends is a perfect substitute for the low interest rates currently being offered by fixed income products.
But dividends from shares are not a straight replacement for fixed income [4].
- A bond is a contractual lending agreement between you and a company in which you lend a set amount to the company and in return the company will repay you interest at an agreed-upon rate and schedule, and at maturity the company will pay you back the amount you originally lent it.
- With shares on the other hand, there is no maturity date, no contractual obligation to pay interest or return capital, and in the event of bankruptcy ordinary shareholders usually get nothing while creditors tend to get some of their capital back.
Dividends are not guaranteed. If the company runs into hard times and isn’t generating enough cash, it can cut or suspend its dividend. As such, investors keen on moving money from low-interest bonds to higher-yielding shares should be fully aware of the differences between shares and bonds [5].
Make no mistake – dividend-paying shares, properly vetted and assembled in a portfolio [6], can be an excellent tool for generating income. The key thing to remember is to not allocate funds to shares for higher yields alone.
Be sure that the funds you’re reallocating to shares will not be needed in the short-term and that you’re comfortable bearing the risks inherent to shares [7].
Until next time
We’ve covered some basics here, but I think it’s important to start from the beginning and build a good foundation of knowledge. In the next article I’ll continue with this bottom-up approach by explaining what we mean by dividend yield.
Until then, please post your comments, questions, and thoughts below!
You can bookmark all The Analyst’s articles on dividend investing [8]. The archive will be updated as new dividend articles are posted.