Dividends explained

Dividends are distributions of profits to stockholders.  Corporations pay dividends; dividends paid by partnerships and sole proprietorships are called “withdrawals” or “drawings.”

“Dividends” generally refer to cash dividends, cash payments to stockholders as a distribution of their profits.  After all, profits belong to the stockholders.

“Stock dividends” actually refer to distributions of stock, when companies distribute actual stock to stockholders.  For example, a 10% stock dividend would give a stockholder who already owns 100 shares an additional 10 “free” shares of stock.

There is some debate over whether dividends are actually good.  If you consider that stock represents ownership in a company, then payments back to stockholders represent liquidation of that ownership back to the stockholders.  Suppose you hold $100 worth of stock and then receive a $2 dividend.  Then your remaining stock must be worth just $98.  Are you any better off?

Some people say that “a bird in the hand is worth two in the bush,” that stockholders are better off with certain cash in their pockets than theoretical cash in their investments.  You just got a $2 return on your investment – of course you’re better off.

Others say that the $2 dividend is money the company chose not to reinvest in its operations, indicating that its growth prospects are limited.

Generally, stocks that pay dividends are considered safer investments, while stocks that don’t pay dividends are considered riskier “growth” companies.

The largest dividend ever was paid out by Microsoft in 2004.  Apple also made news with its recent decision to pay dividends.  This may indicate that the company expects its growth to soon plateau.

Should you reinvest dividends?

[Image courtesy of Wikimedia Commons]

9 thoughts on “Dividends explained

  1. I am a firm believer in dividends. This is one of the best arguments I’ve found on the topic: “Dividends are paid in hard cash. They reflect a company’s ability to generate free cash flow and cannot be disguised or manipulated. Whatever accounting earnings may state, if there is no cash in the bank account, the company cannot pay dividends. Also, if debt servicing cost strain company resources, there is unlikely to be sufficient cash for dividends.

    Dividends also reflect the integrity of management. If cash available for distribution is retained by the company, stockholders are entitled to a full explanation; not just empty rhetoric about “new opportunities”. Remember the old proverb: “A bird in the hand is worth two in the bush”.

    From: http://www.incrediblecharts.com/investing/warren_buffett.php

  2. Yes, Dion, dividends indicate that a company’s operations are generating cash flow. A rarely-used measure for this same issue is Net Operating Cash Flow, on the Cash Flows Statement.

    Growth companies (the kind Warren Buffett stays away from) usually do not pay dividends. These companies will need whatever cash they can get to cover their operating cash needs and capital expenditures. This is why Apple only recently started paying dividends.

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