Things to Consider When Investing in Dividend Paying Stocks

What to consider when investing in dividend vs. non-dividend paying stock

An important component of returns for investors in equity securities are dividend payments, a form of transfer of earnings from the ongoing business operations of the corporation to its stakeholders. But companies don’t always pay dividends, and therefore investors need to carefully consider the value of investing in dividend paying stocks versus non-dividend paying stocks.

To help make the choice that is right for the investor, it is important to first understand what’s behind a company’s decision to pay dividends (or not pay dividends).

Why would a company choose to pay dividends?

Many investors like, want, or even need the steady income associated with dividends. Corporations know this and therefore consider dividends as one way to attract investors. Investors might also be more likely to buy a company’s stock if it pays dividends because they might consider the payment a sign of financial strength or corporate health. Investors also often take dividend payments to mean the governors and managers of the company have a positive or constructive outlook for future earnings, which in turn makes the stock or equity security even more attractive.

Why would a company choose NOT to pay dividends?

Sometimes, however, corporations choose not to pay dividends because management believes reinvesting all of the earnings back into the company will provide greater benefits to shareholders. It is often the case that companies that are young and experiencing quick growth will choose not to pay dividends in order to invest in future growth.

But, even mature firms might not pay dividends. Some mature firms may think they can do a better job of increasing shareholder value (and therefore do a better job of increasing share price) by reinvesting earnings in new projects to diversify business by acquiring assets that are unrelated to the current ongoing business affairs of the corporation. And, sometimes corporations will repurchase some of their own shares with earnings or even buy another company believing they can enhance shareholder value.

Is a lack of dividends a bad thing?

Conventional wisdom suggests that an older company that does not have the same opportunity to reinvest in its own business, but enjoys a prominent position within its industry with stable earnings, will and can afford to make dividend payments. There are many exceptions to this rule, however, and it’s important to note that even companies in good financial health may choose not to pay dividends for a variety of reasons.

The decision to start paying dividends or to increase an existing dividend payment is considered a serious message to the investing community, and a company’s stock price could suffer if it later finds it cannot afford to maintain those payments.

Tax and other considerations

An investor’s decision to buy a stock so that he or she can receive a dividend in lieu of the perceived opportunity to enjoy capital growth through stock price appreciation can have meaningful tax implications. (This is obviously not the case for non-taxable entities such as pension plans.)

To taxable individuals, “capital gains” (the perceived opportunity of stock price appreciation in lieu of a dividend payment) can be more attractive than a dividend. Capital gains are typically taxed at a rate that is lower than a dividend tax rate. Depending upon the jurisdiction in which one lives and pays taxes, dividends may be taxed as income (and this rate is typically higher rate than capital gains taxes), but it is more usual for dividends to be taxed at their own dividend tax rate.

The dividend tax rate is typically greater than the capital gains tax rate, but less than the income tax rate, so anyone looking at investing in dividend or non-dividend payers should seek professional tax advice to avoid unpleasant surprises.

Making the right decision

Trained professionals are best prepared to discern whether dividend payments are a sign of strength, weakness or neither. These trained professionals, or “portfolio managers,” are educated and experienced and they are subject to regulatory oversight. Portfolio managers offer this expertise through portfolio solutions available to investors in the form of mutual funds or other packaged solutions. However, even portfolio managers can misinterpret dividend policy and any implied messaging, so it’s important that investors know the reputation and performance track record of a portfolio manager before making an investment decision.

Choosing a good portfolio manager can be a very difficult task and so it is very common to use the services of “financial advisors.” Financial advisors are meant to not only understand the investment landscape and the participants on that landscape (like portfolio managers), but they are also trained to know and understand an individual’s personal financial considerations. Those would include the investor’s personal risk tolerance, the appropriateness of products for that investor and the unique tax considerations for the individual investor. Financial advisors are very typically employees of large financial corporations who are well capitalized and also benefit from regulatory oversight. Reputable firms have internal mechanisms to help protect individual investors through compliance procedures and good management practices.

Conclusions

A company’s dividend policy and whether it pays a dividend or not may contain important information for individual investors that is not easy to discern. Portfolio managers are trained to know what if any message can be gleaned from a corporation’s dividend policy. Choosing a portfolio manager can be difficult and so a financial advisor is very helpful to individual investors who aren’t suited to making this decision. Moreover, financial advisors need to know and understand individual investor risk tolerance and tax considerations.

3 years ago